A Dozen Things I have learned from Steve Anderson About Business and Investing


Steve Anderson is the founder of the pioneering “micro VC” Baseline Ventures. What is a micro VC?  As the name implies, micro-VCs are smaller versions of more traditional venture firms (e.g., they raise less money and invest smaller amounts at an earlier stage in life cycle of the startup business). Mattermark writes about the category: “Most (around 80 percent) of the initial investments that micro VC firms make are in companies that are at the seed stage, whereas traditional VCs tend to focus on later or across multiple stages.”

Anderson raised his first $10 million fund in 2006 and most recently raised a $100 million fund in just four weeks. Before entering the venture capital business, Anderson worked at eBay, Microsoft, Kleiner Perkins, Starbucks and Digital Equipment Corporation. Baseline Ventures has invested in more than 75 businesses and generated more than 25 financial exits. Among the more famous Baseline Ventures investments are its early investments in Instagram and Twitter.

Venture capital is obviously itself a business and innovations like micro VC (e.g., Baseline), platform (e.g., a16z), compensation and governance (e.g., Benchmark) happen. As examples of this phenomenon, I recently wrote about two other innovators: Jessica Livingston who was a co-founder of Y Combinator and Chamath Palihapitiya who plans to transform his business into something that looks similar to Berkshire.

Here are the customary dozen quotations:


  1. “In 2006 I was starting to ruminate on the idea of founding a company. When I began to think about raising seed capital there were few alternatives to consider.” “The average exit over the last ten years on average has been $100 million. If I own 10% of a $100 million outcome that is real money for me and my co-founders.  Why isn’t anyone [in venture capital] aligned for that sort of outcome?” There is an informative video on YouTube in which Chris Dixon and Anderson talk about how early in their careers they each wanted to finance their own businesses and found themselves faced with a requirement that they sell more than half of the equity in the business just at seed stage to get the cash they needed.  In an email to me, Chris Dixon described the situation he encountered then in this way:


“When I started my first VC-backed company in 2004 there were 10-20 firms who might consider investing in consumer internet companies, and they were all bigger VC funds that were designed to invest in Series A or later. In our seed round we had to give up >50% of the company for 2.6M (plus the deal was tranched which added other challenges). It was pretty obvious that the market needed a new product. I ended up co-founding my own seed fund (Founder Collective) and investing in Baseline, Lowercase, and a few other people who saw the same opportunity.”


What most experienced founders want at seed stage is a lead professional investor who can add more than just capital to the business (for example, a range of startup experience and company building skills). What do I mean by professional investor? In my dozen things profile of Keith Rabois I quote him as saying: “There are fundamental differences between an angel, what I call an amateur investor and being a professional investor, a venture capitalist.” Professional investors are more than just wealthy and well-connected. They can add the benefits of their networks and business skills to the businesses they invest in. It is common to have non professional Angel investors in a seed round. But it is generally not optimal to have no professional investor involved in a seed round. I again agree with Keith Rabois: “If you have the option, raise money from one lead investor who has the right skill set, background, and temperament to help you.” Exclusively raising funds in the form of $25K to $50K checks from a long list of nonprofessional investors like florists and dentists is not optimal.  Some seed round can become what Tom Tunguz recently described: “Party rounds symbolized the heyday of the startup seed market just last year. Called parties because of the number of investors who collaboratively financed seed rounds of startups, the lists became almost comically long as seed sizes ballooned and investor syndicates swelled with them.”

Fast forward to today from the period of time when Steve Anderson and Chris Dixon were both having a hard time raising funds for their startups without massive dilution and there are more seed stage venture capitalists (374 at last count) offering much more attractive terms, assistance and valuations to founders. The investment climate now in micro VC is robust according to data provided by my friends at PitchBook:


Data on angel and seed rounds more generally can be seen here:



  1. “You have to sell at least 20% of your company at every financing [if it’s a big venture fund involved since they need to put a lot of money to work to justify the deal].” Traditional venture capital firms can only sit on so many boards and help only so many startups at any given time. They have a high opportunity cost and in many cases can’t invest without taking a significant equity stake. It should be noted that not every business is right for  venture capital. Many businesses should not raise venture capital at all and are better off trying to financially bootstrap. Fred Wilson has a post on how he invests in “media, food products, restaurants, music, local real estate, local businesses” which he explains in the form of an example: “…the investors put in $400k, get $100k back for four years in a row (which gets them their money back), but then the business declines and eventually goes out of business in its seventh year. The annual rate of return on the $400k turns out to be 14% and the total multiple is 1.3x.”


  1. On average I invest $500k.” If you raise a $100 million fund you can obviously make a lot of seed stage investments. There is not precise formula for how the funds are allocated in any given fund. How much a given seed stage venture capital firm saves for follow on investments varies from firm to firm and from year to year. Mattermark’s data says 20% of investments of micro VC investors are non-seed stage. In general, data from Tom Tunguz says there are less party rounds right now which is a good thing for founders and investors:



  1. “Ten years ago you needed $5 million to start [a business]. Today you need $70 and some coding skills.”  One thing that is remarkable about raising funds at seed stage for a business today is now little cash it takes to fund the company relative to the past. Access to cloud services and modern software development methodology means you need less money and people to create a business than ever before. This lowering of capital requirements is good and bad: good in that it enables people to get ideas to market more effectively and quickly, but bad in that enables a lot of poseurs to flood the market. which often sends confusing signals. Too much money delivered too early into a market is not helpful if you are a founder trying to create a successful business. The best founders do better when there is less noise and more signal in the investing and business environments.


  1. “Generally speaking, most of my investments are pre product launch- they’re just an idea.” There is so much uncertainty and ignorance involved in seed stage investing that a focus on factors like the strength of the team becomes extra important since what an investor is trying to purchase at a bargain is optionality. Investable ideas at seed stage are not easy to find, but the ability to actually execute on those ideas and iterative to adapt at the environment evolves is even harder to find. Most businesses which take a seed stage investment fail. Jason Calacanis wrote this past week: “Startups before their A round — which is where I operate — are a high mortality business. Eight of 10 startups angels invest in, in my experience, are a donut (zero dollars returned).” Not everyone will have the same failure rate as Jason since everyone has a different propensity to take on bets with bigger potential upside, but a higher failure rate. As was stated above, there are no precise formulas in venture capital and investing and business conditions change over time. But there are certainly tendencies that experienced venture capitalists can use to their advantage. As a wise person once said, the past does not repeat itself precisely, but certain things tend to rhyme over the years.


  1. “Your goal is product market fit.” “My goal as an investor is to make sure there’s enough financing to give companies time to do that, a year to 18 months. The worst scenario is to try to raise more money when you haven’t achieved that goal.” “If you don’t have it, eventually you’ll run out of cash, say the experiment is wrong, and fold up your tent … A lot comes down to the entrepreneur. Do you keep doing this against all the feedback, or not? That’s why when I invest I want to leave enough room for pivoting or reexamining your goals. After that, most of the time entrepreneurs are realistic near the end and say this isn’t working. Those decisions aren’t that difficult. It gets more difficult in later stages when you’ve got millions of dollars in. Usually there, you try to sell the company.” Too much money can distract a young business from focusing on what is necessary to create a successful company. Businesses don’t just die from starvation- they can just as easily die from indigestion. And they often do. Ironically, many investors believe the best time to start a business is in lean times. The root cause of a business running out of cash is often that the business lost focus and diverted resources to activities not on the critical path toward success.  Cash starvation or indigestion is often a symptom of bad decisions like premature scaling, trying to do too many things at once or pivoting too often.


  1. “With series A, B, C, or growth investments, you already know what you want to invest in.” Investing in a business before “product market fit” exists means decisions are relatively more instinct-based since the investor has less data. Anderson has even said in an interview that he tends to go with his gut on his seed investments. My blog posts on Eric Ries and Steve Blank set out their thoughts on finding product market fit.  Andy Rachleff describes the process well: “Eric [Ries and I] believe in order to increase the likelihood of succeeding, a startup should start with a minimally viable product to test what he calls a value hypothesis. The value hypothesis should state the founder’s best guess as to what value will drive customers to adopt her product and indicate which customers the product is most relevant to, as well as what business model should be used to deliver the product. It’s highly unlikely that a founder’s initial hypothesis will prove correct, which is why an entrepreneur has to iterate on her hypothesis through a series of experiments before product/market fit is achieved. As a consumer company, you know you have proved your value hypothesis if your business grows organically at a rapid pace with no marketing spend. Only once the value hypothesis has been proven should an entrepreneur test her growth hypothesis. The growth hypothesis covers the best way to cost-effectively acquire customers. Unfortunately many founders mistakenly pursue their growth hypothesis before their value hypothesis.”


  1. “It’s all about networks. I spend time with entrepreneurs, I meet them mostly through other entrepreneurs.” Success begets success. Cumulative advantage is a underappreciated factor that drives the success of any business. For a venture capitalist, investing at the seed stage is a hustle game. By that I means not only the ways in which these investors help portfolio companies but also the ways in which they acquire deal flow and contacts. Reaching out and helping people in advance pays big dividends. Everyone has mentors on how to do things and mine was a wonderful fellow named Keith Grinstein. Pound for pound Keith was the greatest networker I have ever seen. No one even comes close. To illustrate how good he was at networking, when he passed away far too young most everyone at the funeral considered him their best friend.


  1. “You will know if you like [venture capital] well before you know if you are any good at it. “It takes five, six, seven, eight years… the cycles of feedback are long, which is difficult. Becoming a great venture capitalist can take as long as seven to ten years to get right. Sometimes you make a mistake as an investor and don’t pay the price for many years. The long learning curve in venture capital is not only hard but impossible to eliminate unfortunately. Every venture capitalist is to some extent paying the equivalent of tuition every time they invest in a business.  Investments made early in the career of a venture capitalist tend to be more “tuition heavy” than the investments they make later in their career.


  1. “There is a robust seed market now.” “Returns dictate everything. If the asset class has the financial returns, more money is going to come.” There are roughly 375 micro VC firms in the United States. The jury is still out on the right number of micro VCs since the category is so new and surely that number will vary over time as conditions change.  A significant constraint on industry size is the overall level of financial exits for portfolio companies. When micro VCs collectively put X dollars of capital to work they must eventually generate enough financial  exits for their investors or they will not invest enough to keep the category healthy. In other words, venture capital in the medium and long-term is top-down constrained by the aggregate level of financial exits for portfolio companies.Venture capital has been and is likely to always be a cyclical business. In the seed investing category, the presence of angel investors clouds the picture even further.  It is impossible to quantify with any degree of certainty how many Angels are making seed investments at any point in time or their financial returns. People try to quantify the financial returns on Angel investing but there is huge survivor bias and lots of storytelling involved. One relatively recent guess is: “about 300,000 people have made an angel investment in the last two years.” Another guess: “A total of 29,500 entrepreneurial ventures received angel funding in Q1 of 2015.”


  1. “[Accelerators were created] for people who don’t have their own networks or can’t grow their networks. How often do you show up to one place and see 80 companies? Of course with that scenario you’ll pay a higher price because more people are looking. That’s fine. Entrepreneurs have more transparency today than ever before, they can choose the types of investors they want to work with.” It’s great that investors and founders today have so many choices, including participating in accelerators. The more transparent the choices are for founders the better off everyone is. My recent post on Jessica Livingston discusses the benefits of accelerators for founders.


  1. “In this business you will have a long list of things you could have done. If I miss something, I try to learn from that.” Every venture capitalist has investments that they pass on which represent missed opportunities. That is the nature of the business. The important thing is not whether you make mistakes (because you always will to some extent) but whether you learn from your mistakes. I have heard Bill Gurley and Bruce Dunleive of Benchmark Capital say more than once over the years: “Good judgment comes from experience, which comes from bad judgment.”  Absent the direct lesson that comes from making a mistake yourself, reading about other people who do things and fail or succeed can also be helpful, especially if it allows you to avoid “peeing on the electric fence” yourself.



Business insider: http://www.businessinsider.com/steve-anderson-baseline-ventures-instagrams-first-investor-explains-what-he-looks-for-in-companies-2012-4

TechCrunch: http://techcrunch.com/2011/10/25/founder-stories-baseline-ventures-steve-anderson-on-why-he-invested-in-heroku-and-weebly/

YouTube interview: https://www.youtube.com/watch?v=Z0AWCLGk8ow

Micro VC: http://500.co/micro-vc-rising-analyzing-trends-and-the-top-investors-in-the-micro-vc-ecosystem/

Fred Wilson:  http://avc.com/2010/01/how-to-calculate-a-return-on-investment/

Angel Capital Association:  http://www.angelcapitalassociation.org/faqs/

Pitchbook:   https://pitchbook.com/   

Pitchbook charts: http://pitchbook.com/news/articles/the-state-of-the-us-venture-industry-in-7-charts?linkId=23570714

Tom Tunguz:  http://tomtunguz.com/party-in-seed-rounds/

Mattermark:   https://mattermark.com/

Eric Ries post:   https://25iq.com/2014/09/28/a-dozen-things-ive-learned-from-eric-ries-about-lean-startups-lattice-of-mental-models-in-vc/

Steve Blank post: https://25iq.com/2014/10/18/a-dozen-things-ive-learned-from-steve-blank-about-startups/

Andy Rachleff: https://blog.wealthfront.com/venture-capital-economics-part-2/

Center for Venture Research  https://paulcollege.unh.edu/sites/paulcollege.unh.edu/files/webform/Q1Q2%202015%20Analysis%20Report%20FINAL.pdf

Calacanis:  http://calacanis.com/2016/04/21/lions-lambs-in-the-post-unicorn-era/




A Dozen Things I’ve Learned from Mary Meeker about Investing


Mary Meeker is a partner at the venture capital firm Kleiner Perkins Caufield & Byers. Before becoming a venture capitalist she was a Managing Director, Research Analyst, and Technology Analyst at Morgan Stanley from 1991 to 2010. She previously worked at Salomon Brothers. Meeker received her MBA from Cornell.

Meeker and I lived through many of the same events, but in different places, which creates different perspectives. For example, Meeker said once: “I bought my first PC in 1981.”  I bought mine around the same time (an Apple II). We both lived through the rise and fall of the Internet bubble in the 1990s. If you lived through that bubble as a participant, it changed you. Experiences as vivid and intense as the Internet bubble give you fundamentally different muscle memory about finance and the business world. Some people became rich on paper in just months and the impact of that was that envy and jealousy which caused some people to lose their tie to reality. The environment was literally nuts. Fear of missing out made people do things that in retrospect seem insane.

When I said that I was going to write this post on Meeker a few people said to me: “I lost money based on her recommendations in 2000.” I am not going to comment much on that set of issues in this post since Meeker makes her own case in a well-known Newsweek interview. http://www.prnewswire.com/news-releases/newsweek-interview-mary-meeker-morgan-stanley-stock-analyst-71696332.html  I will say that the business model for sell-side research is problematic since few people (if any) are willing to pay for the work.  This creates a free-rider problem and other issues. Meeker is no doubt much happier on the buy-side.

Now for the usual dozen quotations:

  1. “In a typical year, there are generally two technology companies that go public and become 10-baggers, which means they deliver a 10-times return on investment. We were trying to find those two companies.” This statement by Meeker reflects a fundamental truth about the venture capital business. There are firms like 500 Startups which  are following a different venture capital model (see my blog post on Dave McClure) but what Meeker describes is the dominant model. The traditional venture business is all about the Babe Ruth effect (it is magnitude of success and not frequency of success that matters). Fred Wilson just wrote a post in which he explained that his firm loses all of its money in over 40% of its venture investments. This is normal and an essential part of the traditional venture capital business. The number of times something like Facebook can happen in the global economy is top down constrained by a number of factors including addressable market. It is simply not possible to have even a tiny number of Facebook style financial outcomes every few years.


  1. “The race is won by those that build platforms and drive free cash flow over the long-term (a decade or more). That was my view in 1990, 1995, 2000, 2005, 2010, and it remains the same today.” The grand-slam tape-measure home run financial wins that venture capitalists like Meeker seek are most often found in the form of multi-sided markets or platforms. To generate big returns you need a business that scales amazingly well and nothing scales better than software delivered as a service that creates a platform business. You also need a moat and that can sometimes, with a lot of effort and luck, be created through network effects. When a platform is created in the right way it has almost zero marginal cost to deliver the service and thus very attractive margins.


  1. “I [read] an article in the New York Times written by John Markoff about Jim Clark going to the University of Illinois at Urbana-Champaign to invest in a Web browser company called Mosaic Communications run by Marc Andreessen. It was one of those moments. I picked up the paper and said: That’s it. This was 1994. Morgan Stanley then raised money for Mosaic – I actually have that business plan somewhere. The company promised to ‘change the way the publishing world works.’” At the time Mary Meeker describes in the previous sentences I was working for Craig McCaw who is a good friend of Jim Clark.  And Jim Barksdale, who was running McCaw Cellular at that time, would leave to be CEO of Netscape in 1995. So we were very curious about what was going on at Netscape. Craig McCaw sent me and a colleague down from Seattle to visit Netscape to see what Netscape was doing. We were impressed by the products but also the intensity of the battles with Microsoft at the time. Meeker was right that at tat time in history it seemed like liftoff was imminent. By 1995 the launch parties were getting bigger, spending more lavish and the stakes higher. Capital was starting to flood into the technology sector. In one sense, we were all frogs in a pot of water that was steadily getting hotter. People who spout off and say “I would have know what was happening” are fooling themselves. Things were euphoric enough in the markets in 1998-2001 that even the smartest people did dumb things.


  1. “It is one thing to be wrong about the valuation and the timing. It’s another thing to be wrong about the business model.”  I addressed what a business model is in my posts on Steve Blank and Eric Ries. I like the definition used by Mike Maples, Jr.: “The way that a business converts innovation into economic value.” Steve Blank has his own definition: “A business model describes how your company creates, delivers and captures value.” If a startup can’t create, deliver and just as importantly capture economic value, it is going to fail.  A business needs core product value, a scalable delivery system and a moat to protect itself from competitors. Just one or two is not enough. A winning business must achieve all three. In looking at issue like the business model it is possible to make mistakes. If your mistake concerns having an unsound business model that mistake is usually fatal unless you can correct it before you run out of cash. Meeker is saying that valuation and timing are much more solvable problems.


  1. “In general, a good rule of thumb is that for an attacker to beat an incumbent, the attacker’s product typically needs to be 50% better, and 50% cheaper, and sustain that competitive advantage for a year or two, to be able to gain material market share.” There is a lot of inertia in the behavior of humans. Consumers don’t always rationally address decisions like what product to use or whether to stop using a product. People in general in the mass market want a margin of safety when asked to move to a new product. The greater the value differential the lower the cost required to move the mass market customer to a new product. For this reason the value that a challenger must deliver is ratcheted up. The greater the value differential between the new product and the incumbent’s product the lower the customer acquisition cost and the lower the cash that will be burned in getting the business to the critical mass and network effects in my post on that topic.


  1. “Technology stocks are volatile.”  JP Morgan once said the same thing about stocks generally: “The stock market will fluctuate.” And tech stocks can be especially volatile. The best way to deal with volatility is to remember that you can make it your friend. If stock prices were not volatile there would not be as many bargains. Remembering that risk is not the same thing as volatility, is very important.Why ate tech stock more volatile?  Risk, uncertainty and ignorance have been shown to increase when research and development is a high. This is common sense – when conditions impacting a business change more often due to changes in technology prices are going to be more volatile. If tech falls within your circle of competence it can be a great place to invest. Warren Buffett who feel that tech falls outside his circle of competence has said: “I should emphasize that, as citizens, Charlie and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country’s standard of living to rise, and that’s clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride.”


  1. “You never want to catch a falling knife.” A falling knife is a term used to describe the price of an asset that has fallen significantly over a short period, and has significant uncertainty about how much further it will fall. Because momentum and emotions are involved when a knife is falling the risk of mistiming the bottom is significant. Making accurate predictions about human behavior is, ahem, hard to do in a way that creates a significant margin of safety, especially after costs are deducted. It would be great if someone rung a bell when a knife hits bottom, but that never happens. Knives can continue to fall irrationally further down longer that you can remain solvent. If you stay focused on valuation relative to a benchmark like intrinsic value, you are far better off than you will be be trying to time markets. One way to avoid catching a falling knife is to have a margin of safety when buying assets. The idea is that with that margin of safety you can make mistakes or have bad luck and still do fairly well. Having a margin of safety when buying assets is like keeping a safe driving distance between you and a car ahead of you when driving at 70 MPH.


  1. “One of the greatest investments of our lifetime has been New York City real estate, and investors made the highest returns when they bought stuff during the 1970s and 1980s when people were getting mugged. The lesson is that you make the most money when you buy stuff that’s out of consensus.”  It is a mathematical fact that to outperform the market average results the investments must be contrarian in a way that is correct. Buying when other people are fearful can product great bargains. It can also produce great losses to. You must buy assets that are out of consensus and you must be right to outperform the market average. Many smart people have decided not to outperform market averages and instead buy a diversified portfolio of low cost index funds and ETFs.


  1. “Buy [technology stocks] when no one is interested in them. Sell when everyone is interested in technology (or when attendance at technology conferences reaches record levels or when your grandmother wants to buy a hot technology IPO).” This is of course a restatement of the Mr. Market metaphor that was the subject of the previous quote in number 8. Be greedy when others are fearful and be fearful when others are greedy.  But Meeker is making the additional point about the folly stocks tips. When the shoe shine operator at the airport or your Uber driver tells you what stocks you should buy, that is a “tell” that the market is overheated.


  1. “Don’t fall in love with technology companies. Remember to view them as investments.” This statement by Meeker is also a bedrock tenant of value investing. A share of stock is not a piece of paper to be traded but instead a partial interest in a real business that must be understood fundamentally to be properly valued. The business should be evaluated dispassionately based on sound data and analysis and only when it is within your circle of competence. There is significant danger is getting swept up in the madness of the crowd.


  1. “I’ve made my best personal investments when I’ve been a user of the product.” This statement has similarities to a famous statement by Peter Lynch:  “I’ve never said, ‘If you go to a mall, see a Starbucks and say it is good coffee, you should buy the stock.’” Lynch says: “People seem more comfortable investing in something about which they are entirely ignorant.” If you understand the steel industry deeply you are more likely to make better decisions about the steel industry. This is circle of competence thinking. Since risk comes from not knowing what you are doing, it best to be a real users of the product and even more importantly know that industry well. Meeker is famous for her long working hours, 200 slide presentations and extensive research.  Lynch also said once: “Investing without research is like playing stud poker and never looking at the cards.” You can’t understand a business and its place in an industry without doing research. And in doing research you must find something that the market does not properly discount into the price of the stock or bond.


  1. “I love data. I think it’s very important to get it right, and I think it’s good to question it.” The amount of data in Meeker’s massive slide decks is legendary. And of course she has more data than ends up in the side decks. Some of that data is  from companies talking their book and some not. She is saying in this sentence that you need to think carefully about any data to make sure it does not lead you to make a false conclusion. For example, it is easy to confuse correlation with causation. In thinking about any data it is best to avoid acting like the drunk who uses lamp posts for support rather that illumination. Sometimes the data you need is in a dark corner of the parking lot where there is no light. In that case you may need to put the decisions in the “too hard” pile.



Wired:  http://www.wired.com/2012/09/mf-mary-meeker/

WSJ: http://blogs.wsj.com/moneybeat/2015/04/24/mary-meeker-where-is-she-now/

Forbes: http://www.forbes.com/sites/ericsavitz/2012/07/19/mary-meeker-talks-twitter-waze-venture-capital-and-more/#18712f48589c

Fortune: http://archive.fortune.com/magazines/fortune/fortune_archive/2001/05/14/302981/index.htm

Newsweek:  http://www.prnewswire.com/news-releases/newsweek-interview-mary-meeker-morgan-stanley-stock-analyst-71696332.html

Fred Wilson: http://avc.com/2016/04/losing-money/


A Dozen Things I’ve Learned from Jessica Livingston About Business and Investing


Jessica Livingston co-founded Y Combinator in March of 2005. The goal of Y Combinator is to provide seed funding for startups and help get the business to a point where they have “built something impressive enough to raise money on a larger scale.” The next goal is to “introduce the founders to later stage investors—or occasionally even acquirers.”

Livingston has written a book, “Founders at Work” (2007) based on interviews with startup founders including Steve Wozniak (Apple), Caterina Fake (Flickr), Mitch Kapor (Lotus), Max Levchin (PayPal), and Sabeer Bhatia (Hotmail). You can find my post on Y Combinator co-founder Paul Graham (and Livingston’s husband) as well as current Y Combinator President Sam Altman in the Notes.

Prior to co-founding Y Combinator, Livingston was vice president of marketing at Adams Harkness Financial Group. In addition to her work with startups at Y Combinator, she organizes Startup School. She has a BA in English from Bucknell.


  1. “I definitely think of Y Combinator as a startup in many ways. There are origin stories very similar to the way a startup would get started. We were kind of thinking about a problem, and thinking we could do some cool things to solve it.”“We started talking about the brokenness of the funding world in 2004 and it was.” The venture capital business is itself a business. There are many ways that the venture capital business has and will continue to evolve and innovate. Livingston is saying that Y Combinator’s evolution is an example of what a startup must go through to be successful. At the core of sustainable success for a business is always a real solution to a real customer problem. Livingston and the other co-founders of Y Combinator found 1) core product value, 2) a way to successfully deliver it to customers and 3) a significant barrier to entry against competitors from network effects and cumulative advantage. The manner in which firms like Sequoia, Y Combinator, Baseline Ventures, Benchmark Capital and Andreessen Horowitz operate in the venture capital business share elements in terms of the way they operate but also vary in significant ways. That is a good thing since diversity makes the system more resilient and productive. It is through experimentation and trial and error that new value is best discovered. Since most humans like to do what other humans are already doing progress requires that a few outliers exist who will try new things and harvest optionality. Why? Most people would rather fail conventionally, than succeed conventionally. Staying close to the warmth of the herd was a good strategy for most of human evolution. Fortunately, the evolutionary process produces enough oddballs that progress continues to happen. The great entrepreneurs I have worked with in my life are not normal people. They are oddballs in the best sense of the word. That is a very good thing. And no two of them are exactly alike.


  1. “Originally we were targeting programmers and wanted to teach them the business side of running a startup.” What Livingston describes is a noble calling. Huge value is locked up and lost to society when engineers with great ideas can’t bring them successfully to market. I have spent most of my professional life working with engineers who are sometimes challenged when it comes to business. I have seen the full spectrum from people who are business savants to engineers who know just about nothing and have zero desire to do so. The best business mind I have ever seen up close is Bill Gates. Gates ran the business side of the house at Microsoft from the time the business was first established in Albuquerque. He was the CFO and the CEO for many years. Contracts with customers were his responsibility. Gates was able to make these decisions intelligently because he grew up with a lawyer as a dad. His mom Mary was the smartest person in the family and was on many business and nonprofit boards. Mary was a genuine force of nature and would have loved to meet Livingston had she lived longer. It was incredibly fortunate that someone with scarce programming skills like Bill Gates also knew a lot about the law, business, and contracts. He learned these things at places like the dinner table with his mom, dad, two super smart sisters, his grandmother and the many guests who visited. Because of the many conversations that happened at this table and elsewhere Bill Gates understood the difference between a license and an outright sale in the early IBM negotiations which changed business history. Gates also sufficiently understood business, economics, and science that was needed to recognize the value of positive feedback and the likely rise of a new industry based on software. A young man with the right skills and knowledge took IBM in its prime to the cleaners. The types of things that Bill Gates learned at places like the dinner table when growing up, is what engineers learn at a place like Y Combinator. If you want to know a bit more about Mary Gates as a pioneering business leader read #12 in my post on Ann Winblad linked to in the Notes below. Anyone who knew Mary Gates knows that she was amazing.


  1. “What we wanted to do was create a standardized branded form of funding. Y Combinator wanted to be the ‘first gear’ for startups.” “We’re not expecting the money we invest to be the last a startup ever raises.  It’s just to get them going.  And we want to get as many startups going as we can.” Livingston is describing decisions that illustrate the power of focus in creating a valuable business. The founders of Y Combinator decided to focus on a specific problem many startups were facing. In the blog post I wrote on Ann Winblad I quote her as quoting Mary Gates: “Hey, it’s not about how fast you pedal, it’s about how clearly you focus.” The focus of Y Combinator not only creates specialized skills but enables the business to scale. Because of this focus and specialization other later stage venture capital firms view Y Combinator as a partner, which can create a self-reinforcing positive feedback loop which reinforces the moat.


  1. “Our motto is to make something that people want. If you create something and no one uses it, you’re dead. Nothing else you do is going to matter if people don’t like your product.”What guided the founders through this process was their empathy for the users. They never lost sight of making things that people would want.”  The point Livingston is making is so obvious, and yet so often forgotten. If the customers is not having the “A-ha moment” in relation to a product the business will not be sustainably successful. Creating this value in new ways that have a barrier to entry is a rare thing. Creating systems that allow more businesses to do so is also a good. Any successful business like Y Combinator will have imitators and there are many. That is good for society but fortunately, success breeds success and a set of network effects creates enough of a barrier to entry that the business of Y Combinator is attractive.


  1. “At the time we were realizing, ‘Hey, it’s a lot cheaper to start a software company. I mean, all you need is a computer and to pay some of your server costs.’ So we thought, ‘Why don’t VCs write smaller checks?” And finally we said, ‘Let’s do something. Let’s create an investment company that does standardized branded funding. We’ll have an application process and this will be a new thing.’ But we always had thought that we’d do asynchronous investing just like every other investor. But then we said, ‘Neither of us know anything about angel investing. Let’s learn quickly by funding a bunch of startups at once.’” The idea of creating a system that runs startups through a synchronous process is efficient and logical. It reminds me of the many years I spent in school, especially in college and graduate school. There is no question that I learned more from my classmates than I did from my professors. As I interact with accelerators I see just this going on, with founders teaching each other in addition to learning from the program itself. Micro VCs are proliferating to a point where there are more than 350 in the US alone. This means more people are getting funded and that these people are more diverse in every sense. And founders are getting to keep a greater ownership stake in the businesses which increases the probability that the startup will survive the process. Founders who must sell 60 percent of their business at seed stage don’t have the same incentive to persevere in tough times. Cloud services substantially lowering the capital required to start a business also means that founders hold on to a larger stake as they go through the funding process.


  1. “Even Y Combinator got rejected at first. Nowadays there are a lot of groups that do the kind of investing we do, but when we started no one was. Even our own lawyers tried to talk us out of it.”[It’s] really important for people to remember was how often startup founders, that are hugely successful now, get rejected early on will say, “This is a dumb idea. You shouldn’t be working on that. No investor will invest in them.” “I mean, there are countless examples of people trying to raise funding and they just got turned down by investors because they thought it was a bad idea or didn’t think the person was formidable enough. That’s important because it’s hard to start a startup. If you’re a first time founder, you’re going to get rejected a lot in a lot of different ways, and it’s really hard.” Livingston is arguing that the non-consensus, contrarian view is powerful and significant. Howard Marks too argued that to earn more than the market return you must adopt a non-consensus view and that view must be sometimes correct in a significant way. This is all provable with mathematics. If you read even a few of the many posts in this series you see that same point made again and again in different ways. If your idea is not a little crazy then other people are very likely to be working on it. And there is unlikely to be undiscovered optionality which is what drives venture capital returns.


  1. “Perseverance is important because in a startup nothing goes according to plan. Founders live day to day with a sense of uncertainty, isolation, and sometimes lack of progress. Plus startups, by their nature, are doing new things, and when you do new things people often reject you.” “In general, your best weapon is determination. Even though we usually use one word for it, it’s actually two – Resilience and Drive. One reason you need resilience is that you’ll get rejected a lot. Everyone you encounter will have doubts about what you’re doing.” This drives home the point I have made repeatedly in this series of blog posts: missionaries are far more likely to survive than mercenaries. Steve Jobs said in 1995: “I’m convinced that about half of what separates successful entrepreneurs from the non-successful ones is pure perseverance.” Bill Gates has said similarly: “Perseverance has been characteristic of our great success.”


  1. “The media often glamorizes successful founders and makes their paths seem easier than they actually were.” “Just be determined, and have a little luck.” There is way more luck involved in life than people imagine. And yet the lucky have often gone through a not very glamorous crucible. You will hear people say sometimes that they worked hard to get lucky. The reality is that there is no way to increase your luck because anything you do to improve the probability of a positive outcome is skill. On luck, always read Michael Mauboussin. Then read him again. There is seldom a substitute for hard work and perseverance in the life cycle of a startup.


  1. “Starting a startup is a process of trial and error. “A lot of the startups in the book, and I see this again in Y Combinator startups, they start out saying, “We’re going to do this.” They try to do it and it doesn’t really stick, and so they think, “Oh, gosh. The users are actually more interested in this aspect of our site,” and they work on that. So there’s a lot of trial and error, and it gets glamorized, I think, in the press with these successful startups. They say, ‘Oh, he had this brilliant idea. We knew this was going to be big and it was great.’ That’s not the way it usually is. It’s usually a lot of testing one thing out, if not working, and then happening up on the right thing.” “People think startups grow out of some brilliant initial idea like a plant from a seed. But almost all the founders I interviewed changed their idea as they developed it.” I have written several posts on the importance and value of optionality for business and society. The first post is on the ideas of Nassim Taleb, the second on who venture capitalist harvest optionality and the third is on Jeff Bezos. Mistakes are essential to harvesting optionality since that is how information is acquired which enables the benefits of optionality to be captured. In his most recent shareholder letter Jeff Bezos writes: “I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it’s going to work, it’s not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there. Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a 10 percent chance of a 100 times payoff, you should take that bet every time.”


  1. “Innovations seem inevitable in retrospect, but at the time it’s an uphill battle.”  Wikipedia describes hindsight bias well: “Sometimes called the ‘I- knew-it-all-along’ effect, the tendency to see past events as being predictable at the time those events happened.” Most people say to themselves as they go through life: “Hey I thought of that idea a long time ago.” OK, what the hell did you do actually about it then? Read Kahneman and Thaler on this tendency and you will greatly benefit. People are not always rational and they are not always fully informed. The more you understand this about yourself the fewer mistakes you will make. You can, by paying attention, sometimes find ways to profit when other people act like boneheads.
  1. “People like the idea of innovation in the abstract, but when you present them with any specific innovation, they tend to reject it because it doesn’t fit with what they already know.” Livingston is describing how powerful “person-with-a-hammer-syndrome” can be. The most interesting example I ever saw was how AT&T saw mobile in what I call the early days of mobile telephones. The mobile phone was definitely an innovation. McKinsey in its famous botched study vastly underestimated demand for mobile phones service thinking that no one would use them when they had access to a land line. As Livingston observers, mobile phones did not fit with what McKinsey and AT&T already knew. Even when AT&T bought McCaw Cellular in 1995 they thought they were doing so to save the long distance business. I’m not joking about this. I remember at the time Craig McCaw laughing at this fact and lamenting that he had to sell AT&T the entire business since you can’t partner with a firm that does not understand core product value and the industry itself. AT&T had the cash from its legacy business to pay off the debt used to build the industry so it was felt that the deal needed to be done. AT&T bought McCaw Cellular for the wrong reasons but it was the right decision anyway. Better to be lucky than good, as they say.

  1. “Investors, most of them, have a herd mentality. They want to invest only if other people are investing. It’s like a Catch-22 like not being able to get a job because you don’t have enough experience.” The best and most experienced founders and the better venture capitalist know how to harness this aspect of human nature. People like to do what other people are doing. It is efficient from an informational standpoint. They also like to get in the side car of people who they see as successful. Richard Zeckhauser has written a great paper on this which is well worth reading. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2205821 Key bits from the Zeckhauser include: “Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop real estate or new technologies. Those who lack these skills can look for ‘sidecar’ investments that allow them to put their money alongside that of people they know to be both capable and honest.” The critical point is to know when to deviate from the herd. Most of the time the herd is right. The trick is to know when the herd is wrong. Always being a contrarian is suicidal. You must be contrarian and you must also be right about that contrarian view to out-perform the market average.



Founders at Work:  http://www.amazon.com/Founders-Work-Stories-Startups-Early/dp/1590597141

Most Memorable Quotes from Startup School 2012 http://www.jasonshen.com/2012/the-most-memorable-quotes-from-startup-school-2012

Fortune http://fortune.com/2016/04/04/y-combinator-jessica-livingston/

Founders at Work http://foundersatwork.posthaven.com/what-makes-founders-succeed

Venture Beat http://venturebeat.com/2015/08/23/sam-altman-and-jessica-livingston-explain-y-combinators-success/

TechCrunch Interview http://techcrunch.com/2011/01/26/yc-co-founder-jessica-livingston-on-the-dearth-of-women-in-tech-and-some-steps-to-fix-it /

Business Insider http://www.businessinsider.com/the-advice-for-any-woman-who-wants-to-found-a-startup-2011-1

Interview: The Next Women http://www.thenextwomen.com/?q=2009/05/01/interview-y-combinator-founder-jessica-livingston

Mixergy Interview  https://mixergy.com/interviews/y-combinator-jessica-livingston-interview/

Bloomberg Interview: http://www.bloomberg.com/news/videos/2014-10-10/paul-graham-jessica-livingston-studio-10-1009

The Macro: http://themacro.com/articles/2015/11/jessica-livingston-startup-school-radio/

Paul Graham on Jessica Livingston:  http://paulgraham.com/jessica.html

Startup Grind Interview:   https://www.youtube.com/watch?v=zMZZPiJrBo0

Stanford Interview: https://www.youtube.com/watch?v=syEVbr_2KXQ

Women 2.0 Interview https://www.youtube.com/watch?v=qEceEtgkZFg

Mauboussin: http://www.michaelmauboussin.com/

My post on Paul Graham  https://25iq.com/2014/08/16/a-dozen-things-ive-learned-from-paul-graham-2/

My post on Sam Altman  https://25iq.com/2015/07/17/a-dozen-things-ive-learned-from-sam-altman-about-venture-capital-startups-and-business/

My post on Ann Winblad in which she refers to Mary Gates: https://25iq.com/2014/08/02/a-dozen-things-ive-learned-from-ann-winblad/


A Dozen Things I’ve Learned from Chamath Palihapitiya About Investing and Business


Chamath Palihapitiya is the founder of the venture capital firm Social Capital. Chamath lived in Sri Lanka until he was 6 when his family moved to Canada. He is a graduate of the University of Waterloo, where he achieved First Class Honors in Electrical Engineering. Chamath was an early member of the Facebook senior management team. He was Facebook’s VP of Growth, Mobile & International. Prior to joining Facebook in 2007 Chamath held senior positions at AOL (Vice President and GM of AIM and ICQ), Mayfield Fund (a venture capital firm in Silicon Valley), Winamp and Spinner.com. He is also an owner of the Golden State Warriors. The mission of Social Capital “is to transform society by using technology to solve the world’s hardest problems.” The venture capital firm’s portfolio includes or has included ownership in businesses like Yammer, SecondMarket, Slack, and Box. Chamath has said: “We’re going to build an organization that looks different than a venture firm. That organization is going to be this hybrid, bastard-stepchild of Berkshire Hathaway and Blackstone and Blackrock. We want to have a large permanent capital base and we want to basically take really long discontinuous bets on companies and sectors and trends.” What I find most interesting about Chamath is the originality of his thinking. Writing this post was harder than usual. No draft has ever changed so much between my first draft and my final post. I re-read and re-listened to a number of the interviews and each time I went back to my draft and made what I had previously written simpler.

The Dozen Things said by Chamath that I selected for this post are:


  1. “Most people when they think about growth they think it’s this convoluted thing where you’re trying to generate these extra normal behaviors in people. That’s not what it’s about. What it’s about is a very simple elegant understanding of product value and consumer behavior.” “Winamp [taught me] about core product value. What it means is: create a real connection with someone. I think now we all euphemistically call it the ‘A-ha’ moment with the consumer. But also the power of how these communication networks when they develop create real entrenched usage and scale, and how these things can just dramatically accelerate adoption and engagement.” After all the testing, all the iterating, all of this stuff, you know what the single biggest thing we realized [at Facebook]? Get any individual to seven friends in 10 days. That was it. You want a keystone? That was our keystone. There’s not much more complexity than that.” “It’s not just top-line growth. It’s acquisition, engagement, ongoing product value. It’s understanding the core value and convincing people that may not want to use it.” “What we did at that company was we talked about nothing else. Every Q&A, every all hands nothing was spoken about other than this. Monetization didn’t really come up. Platform came up but again in a secondary or tertiary context. But it was the single sole focus. But because we had defined it in this very elegant way that expressed it as a function of product value it was something that everyone could intrinsically wrap their arms around.” “Knowing true product value allows you to design the experiments necessary so that you can really isolate cause and effect.  As an example, at Facebook, one thing we were able to determine early on was a key link between the number of friends you had in a given time and likelihood to churn. Knowing this allowed us to do a lot to get new users to their ‘A-ha’ moment quickly.  Obviously, however, this required us to know what the ‘A-ha’ moment was with a fair amount of certainty in the first place.”   I stitched this set of quotes together from several sources identified in the Notes below. There are a number of excellent interviews with Chamath on YouTube that I enjoyed watching. I always learn a lot doing the research for these posts but in this case I learned more than usual since he is such an original thinker. In the interviews he repeatedly says that there is no substitute for delivering “core product value” to the customer, which he says is far harder and rarer than most people imagine. He is adamant in his view that metrics measuring factors that do not relate to core product value like the number of invitations sent to friends can be not only distracting but harmful. For Facebook, Chamath says that the keystone was: “get any individual to seven friends in 10 days.” Once that keystone was achieved Facebook customers were receiving enough core product value that they were unlikely to churn and more likely to recommend the service to others because they reached the A-ha moment. If a business does not know what the A-ha moment is for its product in the first place, they are highly unlikely to succeed. Getting distracted by theories about monetization, virality or other factors can be an impediment to creating the scalable connections with customers that create operating leverage. This slide from a presentation by Chamath makes the point about core product value:



  1. “[At Facebook, to generate growth] we actually just looked at a lot of data, we measured a lot of stuff, we tested a lot of stuff, and we tried a lot of stuff. Now that masks over a lot of more nuanced understanding but at an extremely high level that’s really what we did. What’s shocking to me is when I see a lot of products out there it’s unbelievable to me that people are trying to shroud products in this veneer of complexity. … Measure some shit. Try some shit. Test some more shit. Throw the stuff that doesn’t work. It’s not that complicated.” Chamath is saying that a business must measure the right things if the process is going to be useful. What a business measures as a keystone must capture its core product value. For example, measuring daily active users (DAU) is not the right keystone since it doe snot capture core product value.  Justin Kan sent a tweet recently that said: “Startups mostly don’t compete against each other, they compete against no one giving a shit.” If a business does not deliver core product value no one will care and notifications or invites will be viewed as spam.



  1. “Most people and most companies can barely get one thing right. We all kid ourselves about doing so many different things but there is a value to focus, which is, it constrains optionality and it forces you to have clarity of thinking. Because otherwise what happens is you have all these outcroppings of people within a company that can have their own anecdotal point of view about any kind of random thing. If they practice that rhetoric enough they sound like they know what they’re talking about. Then what happens is you invariably try a bunch of different things and then you end up nowhere. But if you constrain the problem to say there’s one thing. It forces everyone to be an expert or know that one thing, then speak intelligently and most importantly factually about that one thing.” Anyone who has worked at an actual business knows there are always challenges inside EVERY company. Nothing is ever prefect. Maintaining focus is essential. Clarity of thinking and action is powerful when done right. I have written a blog post on Jim Barksdale who likes to say: “The main thing is to keep the main thing, the main thing.” Every business has a profit engine that lies at its core. And that engine is invariably simple if you strip away everything extraneous. Two former Barksdale colleagues write about this about the main thing principle: “We loved that expression when we first heard it from Jim Barksdale, then the COO of FedEx. That single sentence captures the greatest challenge that executives and managers face today: keeping their people and their organizations centered on what matters most.  Every organization needs a Main Thing—a single, powerful expression of what it hopes to accomplish. Without it, it’s not possible to align the four elements that produce organizational efficiency and effectiveness: strategy, people, customers, and processes.”


  1. “Users are only ever in three states — they’ve never heard about it; they’ve tried it; and they use it. What you’re managing is state change. So the framework is, what causes these changes? The answer should be rooted more in preference, choice and psychology than in some quantitative thing.” What I want to hear about is the three most difficult and hard problems that any consumer product has to deal with. How to get people on the front door? How to get them to an ‘A-ha’ moment as quickly as possible? And then how do you deliver core product value as often as possible? After all of that is said and done only then can you propose to me how you are going to get people to get more people. That single decision about not even allowing the conversation to revolve around this last thing in my opinion was the most important thing that we did.” “I hate the term ‘growth hacker’. There are a lot of snake-oil salesmen in this field. Let’s not create some wizard-behind-the-curtains thing about this concept called growth hacking. It existed well before me. It’s called product and marketing.” “Most companies in e-commerce right now are negative-gross-margin businesses. Amazon has such enormous scale, and they’re at about 13 or 14 percent gross margins, but on a huge number. In order to compete with Amazon, these businesses have to sell goods for less than what they cost. These companies are in the delivery businesses (Postmates, DoorDash, Instacart) and in the food business (SpoonRocket, Munchery). Basically, a lot of these new-generation, remote-control-type businesses—where the phone acts like a remote control to replace an offline experience—are generally, to date, highly, highly, highly unprofitable. There’s a lot of what I call “venture philanthropy” to prop these businesses up. Time will tell whether any of those can become a real business. If a shoe costs $20, Nike doesn’t sell it for $14. They sell it for $400. We have to get back to this world of having pretty reasonable discipline on business models and understanding that many of these gross-margin businesses will never, never break even or become profitable.” One of the more interesting things happening today in business is how businesses generate these three phase changes Chamath describes above (they’ve never heard about it; they’ve tried it; they use it). Slack CEO Stewart Butterfield said recently: “I think we can get away with not having a sales team in any kind of traditional way probably forever. This is how we have grown so far, and we’d like to continue this forever, which is — people really like it and so they tell other people about it, and then other people start using it. And that’s by far the best because when someone you trust tells you that this thing is good, then you’re much more likely to be inclined to use it.”


  1. “1) Approach with humility; 2) Have strong opinions but weakly held; 3). Change your mind a lot; and 4) Experiment and iterate.” Encountering high levels of risk, uncertainty and ignorance is inevitable, especially when it comes to anything related to technology. Being humble is a great way to stay within your circle of competence and avoid other dysfunctional heuristics like over-optimism, person with a hammer syndrome and overconfidence.  Having strong opinions is important since that tends to mean you have developed strong arguments that support your views. But at the same time those strong views should be weakly held because otherwise you may become a victim of dysfunctional thinking approaches like confirmation bias. The justification for changing your mind a lot has to do with being able to profit from optionality. Nassim Taleb has said: “A rigid business plan gets one locked into a preset invariant policy, like a highway without exits —hence devoid of optionality.” Taleb wrote in his book Antifragile: “The idea present in California, and voiced by Steve Jobs at a famous speech: ‘Stay hungry, stay foolish’ probably meant ‘Be crazy but retain the rationality of choosing the upper bound when you see it.’ Any trial and error can be seen as the expression of an option, so long as one is capable of identifying a favorable result and exploiting it.”


6. “Success begets more success.” I’ve written about the self-reinforcing nature of success many times. Cumulative advantage is everywhere in the world today if you know how and where to look for it. This “success begets success” phenomenon has always existed, but not in terms of the magnitude of its impact.  Once the world went digital and was increasingly connected by networks, the impact of cumulative advantage was accelerated. Chamath’s life is particularly interesting in no small part because he was involved in one of the most striking versions of cumulative advantage (Facebook) in business history and is funding many other firms through Social Capital that benefit from the phenomenon. Even the Golden State Warriors benefit from cumulative advantage since the more success the basketball team has the more great players (particularly great team players who want to win) want to play there. Additionally, the more success the team has, the more revenues rise, which enables more success [repeat]. A business can generate benefits from cumulative advantage in just the same way as a basketball team. Jack Dorsey said something recently that made me think he believes he can learn a lot about cumulative advantage from this basketball team: “To clear my head, I wake up super-early. I exercise, and have been fascinated by the Golden State Warriors. And I learn a lot from them and their team dynamic. I think what’s really important to me right now in my own leadership is understanding how to build a great team dynamic instead of just hiring a bunch of individuals and heroes. Like, how do we actually build something—a team, and folks who add to the team? And creating a team like the Warriors; that it’s not entirely dependent on one person, but this bench that they have.”


  1. “How to pick a VC:  1) Must be a good picker. 2). Must create interest from others for follow-on. 3) Can help you grow.  4) Is morally aligned.” “[A founder] can’t afford to be in a situation where in the absence of operational help you could run out of oxygen.” “You want to have a situation where your venture investors have the benefit of the doubt with other investors.” The reputation of certain venture capitalist has significant signaling effects with other venture capitalists and potential employees. When uncertainty and fear is high, humans have a tendency to form herds and follow pack leaders. The right venture capitalist can get a business through a rough patch. If a business has raise money from a motley crew of investors and there are no leaders, if times get tough or uncertain there may be no one leader to step up and inspire confidence among the other investors or potential new investors. A founder is essentially entering into a marriage with the venture capitalist so it is important to choose well. Chamath has said in several settings that if the founder is not morally aligned with his venture capitalist big problems can result.


  1. “The business model of the future is to serve individuals, because individuals are now relatively smarter. That’s not correlated with education, by the way—they are smarter because they have access to tons more information. And so we are all more connected, we are all more engaged, and as a result we are all more cynical. And we all see that the emperor has no clothes. That’s true of banking, that is true of people who run educational institutions, and it’s true of healthcare. So the model of the future is to basically deconstruct all of that and empower the edges. That is the way you build a multi-gajillion-dollar company. Give people individual power.”  This “power to the people” investing thesis is powerful. I wrote about this topic in my profile of Rich Barton on this blog. Providing consumers with information that was formerly locked up in proprietary information systems means information asymmetry ends. Consumers no longer need to be at a disadvantage when purchasing goods and services since they no longer have less information than the provider. Quality goes up. Service levels go up. The bar gets set higher. A big enabler of all of this is the mobile phone. Everyone has access to high quality product information all the time and the result is phenomena like show rooming (looking on line at prices from many vendors when you are in a physical store).


  1. “Some companies that we invested in sucked. We were wrong about the market or wrong about the people. But in cases where we were kind of right, then we’ll be really right.” “This is the time when people should be building really big, crazy things.” “It really comes down to a very simple thing, which is, the principle of N of 1 vs. 1 of N.” Venture capital is all about grand slam home runs since the failure rate with startups is high. But it is magnitude and not frequency of success that matters in investing (the Babe Ruth Effect). The failure rate is high enough in the venture business that the math dictates that a very small number of winners will determine whether a particular fund will be financially successful.  Venture capitalists are looking for significant optionality (an asymmetric upside) with a downside limited to what they invest (i.e., you can only lose 1X what you invest but the potential upside is many multiples of what you invest).”


  1. “It’s fine to fail. But if you fail because you didn’t have the courage to move to Oakland and instead you burned 30 percent of your cash on Kind bars and exposed brick walls in the office, you’re a fucking moron.” “The company builders are just cheap, they’re just grimy, and just, shitty office space, and they’ve got to keep it under 8 or 9% of their total burn, and they find people who really really believe in the thing they’re making, and they decide to just live in Oakland and pay for Lyft, and it’s still cheaper. They do all kinds of creative things that deserve capital so they can build. So it forces us to ask those questions, ‘How are you really company building?’ And that’s how we get the truth on who’s going to stand the test of time.” “We’re trying to coach our C.E.O.s that the window dressing is both expensive from a cash perspective and tremendously expensive from a culture perspective. It distracts the team from building what they need to build. Don’t waste money on things that get away from your mission, which confuse employees about why they’re actually there. Meaning, the quality of the office and the quality of the food are all part and parcel of a lack of discipline, which speaks to the fact that the mission isn’t compelling enough.” Every penny not spent on achieving the objectives of the business goal is not only wasted but a potentially a contributor to a cash gap that can kill the business. The only unforgivable sin in business is to run out of cash. People who are driven to build a business (missionaries) won’t trade off things like free Kind bars if it increases the risk that they will not achieve their goals. Of course, wasting money is stupid if a founder is more of a mercenary. For example, if a business spends $2,000 on an expensive office chair at seed stage, that chair becomes very expensive indeed if the business eventually has a financial exit at 100X that seed stage valuation.


  1. “Poker is a microcosm of my own life.” Michael Mauboussin likes to point to cigar-chomping gambling legend Puggy Pearson to make point about how there are similarities between playing poker and investing:

“Born dirt poor and with only an eighth-grade education (“that’s about equivalent to a third grade education today,” he quipped), Pearson amassed an impressive record: he won the World Series of Poker in 1973, was once one of the top ten pool players in the world, and managed to take a golf pro for $7,000—on the links. How did he do it? Puggy explained, “Ain’t only three things to gambling: Knowin’ the 60–40 end of a proposition, money management, and knowin’ yourself.” For good measure, he added, “Any donkey knows that.”

Charlie Munger ascribes no small amount of his financial success in investing to the time he has spent playing poker and bridge. Munger has said: “The right way to think is the way Zeckhauser plays bridge. It’s just that simple.” At a fundamental level, investing is just one form of making a bet. It’s essential, however, that the bet be made in a way that is investing (net present value positive) rather than gambling (net present value negative). Investing is inherently a probabilistic exercise and experience with other games of chance can be helpful. The great bridge player and Harvard Professor Richard Zeckhauser points out: “Bridge requires a continual effort to assess probabilities in at best marginally knowable situations, and players need to make hundreds of decisions in a single session, often balancing expected gains and losses. But players must also continually make peace with good decisions that lead to bad outcomes, both one’s own decisions and those of a partner. Just this peacemaking skill is required if one is to invest wisely in an unknowable world.” Buffett also believes that bridge shares many characteristics with investing: “Every hand is different and yet what has happened in the past is meaningful. In investing you must make inferences about every bid or card and cards that are not played. Also, as in bridge, you can benefit from having a great partner and having strong interpersonal skills. Understating probability and statistics is essential in both card playing and investing.”


  1. [What to look for in a founder] “Very high IQ; Strong sense of purpose; Relentless focus on success; Aggressive and competitive; High quality bar bordering on perfectionism; Likes changing and disrupting things; New ideas on how to do things better; High integrity; Surrounds themselves with good people; Cares about building real value (over perception).” “We try to find businesses that are technologically ambiguous, that are difficult, that will require tremendous intellectual horsepower, but can basically solve these huge human needs in ways that advance humanity forward. Those things don’t necessarily take lots of money, but they generally do take lots of time. And they require really mission-driven people.” This is a great list. There is too much there to talk about everything but on the last point, founders who are mercenaries are not as likely to care about building real value. Missionary founders are naturally aligned with the interests of investors and customers. Creating a startup is such a challenging endeavor that having missionary founders significantly increases the probability that the company will prosper because of this alignment. Chamath puts it this way: “What you value is what you achieve.” Core product value must be the goal instead of short-term optimization if you are going to build a sustainable business.



Vanity Fair interview:   http://www.vanityfair.com/news/2016/03/chamath-palihapitiya-interview-says-start-ups-are-mostly-crap?mbid=social_twitter


Semil Shah Interview of Chamath Palihapitiya:   http://blog.semilshah.com/2015/09/17/transcript-chamath-at-strictlyvcs-insider-series/


Chamath Palihapitiya Slide deck:  http://www.slideshare.net/growthhackersconference/how-we-put-facebook-on-the-path-to-1-billion-users


Genius transcript of Chamath Palihapitiya: http://genius.com/Chamath-palihapitiya-how-we-put-facebook-on-the-path-to-1-billion-users-annotated


Interview of Chamath:  https://www.youtube.com/watch?v=ZlYln36BRpo


TechCrunch Interview:  https://www.youtube.com/watch?v=59uTUpO8Dzw


StartupGrind Interview: https://www.youtube.com/watch?v=ncjum-bkW98


Chamath Palihapitiya on Quora: https://www.quora.com/What-are-some-decisions-taken-by-the-Growth-team-at-Facebook-that-helped-Facebook-reach-500-million-users


Wired article:  http://www.wired.co.uk/magazine/archive/2014/09/features/growth-hacking


Chamath Palihapitiya Medium post on values:  https://medium.com/@chamath/values-1d00431c35f1#.wbltxp3mu


Mauboussin:  http://www.jstor.org/stable/10.7312/maub14372


Slack:   http://www.businessinsider.com/slack-ceo-stewart-butterfield-no-salespeople-2016-3?utm_source=dlvr.it&utm_medium=twitter


Nassim Taleb blog post: https://25iq.com/2014/04/05/the-best-venture-capitalists-harvest-optionality-dealing-with-risk-uncertainty-and-ignorance/


Jim Barksdale blog post:   https://25iq.com/2014/05/31/a-dozen-things-ive-learned-from-jim-barksdale-and-barksdaleisms/


Bill Gurley blog post:  https://25iq.com/2013/09/09/a-dozen-things-ive-learned-from-bill-gurley-about-investing-and-business/


Rich Barton blog post:   https://25iq.com/2015/03/01/a-dozen-things-ive-learned-from-rich-barton-about-startups-business-and-investing/


Jack Dorsey Interview:  http://www.bloomberg.com/features/2016-jack-dorsey-twitter-interview/



A Dozen Things I’ve Learned from Dr. Michael Burry about Investing



Dr. Michael Burry is the founder of Scion Capital. He was recently made famous with the general public as a character in the movie adaptation of Michael Lewis’ book The Big Short, but even before then he was famous in investing circles for his astute investing during times like the financial crisis of 2007. Michael Burry is portrayed in the movie by Christian Bale. The real Michael Burry started out as a part time investor and blogger and built his reputation and AUM with great results and original thinking. He is a physician by training and has diagnosed himself as having Asperger’s Syndrome. Burry is particularly interesting for investors in that he has adapted value investing principles to his personality, skills and nature. Like Charlie Munger did many years before, Burry found new ways for value investing to evolve beyond using the system to find “cigar butt” stocks. Burry’s approach indicates that value investing can work for technology and other stocks that people like Warren Buffet may invest in if circle of competence exists and the holding period is not as long that used by someone like Warren Buffett. Technology changes too much to adopt the same holding period as Munger and Buffett. What is Burry doing today? “Michael Burry is still managing a hedge fund named Scion and is still critical of the way the financial system is being run, but now he’s more interested in water than real estate” wrote the author of a New York magazine article who interviewed him in late 2015. Burry’s story demonstrates several important things. Most importantly, the power of being rational and the power of fundamental bottoms up research. It also demonstrates the huge value that permanent capital provides to a rational money manager since as Keynes once said: Markets can remain irrational longer than you can remain solvent. Even as rational as Burry is, it took courage to make and to hold on to the investments that made him famous. Being right, but too early, is indistinguishable from being wrong.

  1. “My weapon of choice as a stock picker is research; it’s critical for me to understand a company’s value before laying down a dime. I really had no choice in this matter, for when I first happened upon the writings of Benjamin Graham, I felt as if I was born to play the role of value investor.” “Investors in the habit of overturning the most stones will find the most success.” “The late 90s almost forced me to identify myself as a value investor, because I thought what everybody else was doing was insane.” Burry has not completely adopted the ideas of Warren Buffett or Ben Graham and has instead developed his own approach that remains true to the fundamental bedrock of value investing. Burry’s example illustrates how it is possible to follow the value investing system and yet have your own unique style. Again, he is at his core a value investor. Burry makes clear in this set of quotes that he treats shares of stock as a partial ownership of a real business and that understanding any business requires research. You must genuinely understand of the underlying business. A share of stock is not a piece of paper to be traded like a baseball card. The movie version of The Big Short conveys that the style of Burry has a lot more stress associated with it than a Buffett approach, but for Burry it has worked out well financially.


  1. “All my stock picking is 100% based on the concept of a margin of safety, as introduced to the world in the book “Security Analysis,” which Graham co-authored with David Dodd. By now I have my own version of their techniques, but the net is that I want to protect my downside to prevent permanent loss of capital. Specific, known catalysts are not necessary. Sheer, outrageous value is enough.”  “My firm opinion is that the best hedge is buying an appropriately safe and cheap stock.” “It is a tenet of my investment style that, on the subject of common stock investment, maximizing the upside means first and foremost minimizing the downside.” Burry reveals in these statements that he keeps the core value investing faith by always using a “margin of safety” approach. When Burry says: “Lost dollars are simply harder to replace than gained dollars are to lose” it is another way of saying what Warren Buffett has said many times: “The first rule of investing is: don’t lose money; the second rule is don’t forget Rule No. 1.” Joel Greenblatt agrees: “Look down, not up, when making your initial investment decision. If you don’t lose money, most of the remaining alternatives are good ones.” Seth Klarman writes in his book of the same name: “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” An investor who purchases shares in a business at a price that reflects a margin of safety can make a mistake and still do well financially. When Burry refers to “catalysts” he is talking about the events that I wrote about in my post on Mario Gabelli, who has said: “A catalyst may take many forms and can be an industry or company-specific event. Catalysts can be a regulatory change, industry consolidation, a repurchase of shares, a sale or spin-off of a division, or a change in management.” Burry, Buffett, Greenblatt, Klarman, Gabelli all think about margin of safety first. It is not an optional part of value investing.


  1. “I try to buy shares of unpopular companies when they look like road kill, and sell them when they’ve been polished up a bit.” “Fully aware that wonderful businesses make wonderful investments only at wonderful prices, I will continue to seek out the bargains amid the refuse.” The third bedrock value investing principle is: Mr. Market is your servant and not your master. Howard Marks makes the same point Burry is making about the necessity of sometime being contrarian: “It is our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling – and if our view turns out to be right – that’s the route to the greatest rewards earned with the least risk…. To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Adopting the popular viewpoint will not result in market out-performance if the popular forecast is also right. Some roadkill is really roadkill, and some refuse is really refuse.  Finding an out-of-favor business selling at a substantial bargain and then waiting is the name of the value investing game. It is easier to say than do.



  1. “If you are going to be a great investor, you have to fit the style to who you are. At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules.… I also immediately internalized the idea that no school could teach someone how to be a great investor. If it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.” “Ick investing means taking a special analytical interest in stocks that inspire a first reaction of ‘ick.’ I tend to become interested in stocks that by their very names or circumstances inspire unwillingness – and an ‘ick’ accompanied by a wrinkle of the nose on the part of most investors to delve any further.” In his book The Big Short Michael Lewis describes Burry’s view: “The lesson of Buffett is, to succeed in a spectacular fashion you have to be spectacularly unusual.” The movie version of The Big Short certainly portrays Burry as a very usual character due to his Asperger’s syndrome. Burry believes he has an advantage in the investing process since Asperger’s allows him to be more rational/less emotional.  There will be times when Mr. Market will offer up shares in a business at a price that reflects a substantial margin of safety, and to find that bargain wise investors try to find something that is out-of-fashion.  Burry believes there is no better place to look for something that is out-of-fashion than the “ick” category.



  1. “I prefer to look at specific investments within the inefficient parts of the market.” “The bulk of opportunities remain in undervalued, smaller, more illiquid situations that often represent average or slightly above-average businesses.” “In essence, the stock market represents three separate categories of business. They are, adjusted for inflation, those with shrinking intrinsic value, those with approximately stable intrinsic value, and those with steadily growing intrinsic value. The preference, always, would be to buy a long-term franchise at a substantial discount from growing intrinsic value.” Markets are often efficient but that does not mean that they are always efficient. If you work hard at the research side of investing and are diligent Burry believes that bargains can be found. The bargains may not always be found within your circle of competence and may not be available for very, long but if you are aggressive and willing to act quickly Burry believes there are big opportunities for an investor.


  1. “It is Buffett, not Graham that espouses low turnover. Graham actually set targets: 50% gain or 2 years. That actually ensures rather high turnover.” The actual Ben Graham quote from an interview is: “If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price.” This statement by Graham is not consistent with Warren Buffett’s view of the world, but it is perfectly acceptable for a value investor to do as long as the holding period is not so short that it falls within the definition of speculation. Burry feels comfortable buying stocks and other assets that Buffett would avoid. Both approaches are still value investing.



  1. “Credit-default swaps remedied the problem of open-ended risk for me.  If I bought a credit-default swap, my downside was defined and certain, and the upside was many multiples of it.” Burry is describing a classic example of positive optionality that I discussed in my post on Nassim Taleb: “Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny).” If you can buy positive optionality at a bargain price that investment can be very valuable. It is of course possible to overpay for optionality.



  1. “A Scion portfolio will be a concentrated portfolio.”The Fund maintains a high degree of concentration – typically 15-25 stocks, or even less. Some or all of these stocks may be relatively illiquid.” “I like to hold 12 to 18 stocks diversified among various depressed industries, and tend to be fully invested.” Burry is what Charlie Munger calls a “focus investor” since he concentrates his bets. For Burry, owning a small number of stocks in “various depressed industries” is enough diversification. This means he does not buy a dozen health care stocks. In other words, Burry diversifies based on categories.


  1. “One hedges when one is unsure. I do not seek out investments of which I am unsure.” It is always wise to have what Charlie Munger calls a “too hard” pile and avoid investment about which you are unsure.  But this approach is especially important if an investor has as few as 12 stocks in their investment portfolio like Burry. One way to make peace with this approach and avoid hyperactive investor syndrome is to realize that you can be a successful investor by making only one of two sound decisions a year. Joel Greenblatt says: “Even finding one good opportunity a month is far more than you should need or want.”


  1. “How do I determine the discount? I usually focus on free cash flow and enterprise value (market capitalization less cash plus debt). I will screen through large numbers of companies by looking at the enterprise value/EBITDA ratio, though the ratio I am willing to accept tends to vary with the industry and its position in the economic cycle. If a stock passes this loose screen, I’ll then look harder to determine a more specific price and value for the company. I also invest in rare birds — asset plays and, to a lesser extent, arbitrage opportunities and companies selling at less than two-thirds of net value (net working capital less liabilities). I’ll happily mix in the types of companies favored by Warren Buffett — those with a sustainable competitive advantage, as demonstrated by longstanding and stable high returns on invested capital — if they become available at good prices.”  Burry is not like Buffett in every way and not like Graham either. Burry shows how it is possible to follow the value investing system and yet have your own unique style. But he is still a value investor since he buys at a price that reflects a margin of safety, does not make Mr. Market his master and treats shares of stock as a partial ownership of a real business. Burry’s style is opportunistic and fits with who is he is.  You are not Michael Burry and neither am I. Most everyone is far better off investing in a low cost portfolio of diversified index funds.


  1. “Volatility does not determine risk.” “I certainly view volatility as my friend. Volatility is on sale because 99% of the institutions out there are doing their best to avoid it.” “I will always choose the dollar bill carrying a wildly fluctuating discount rather than the dollar bill selling for a quite stable premium.” Michael Mauboussin has a wonderful description of volatility that I like a lot.


“A lot of value investors shun concepts such as volatility, or standard deviation, as a measure of risk — and I’m sympathetic to that point of view. That said, the notion of risk is very time-dependent. For very short periods of time, volatility is a pretty good way to think about risk. I have kids in college and I have to write a check for their tuition, so volatility is a very important concept for me. I want to minimize my volatility so I can make sure I can write that check. Or if you go out to an options desk and say, “Options traders, we’re taking away your measure of implied volatility,” they would actually be very much hamstrung. But if you take a long-term point of view, which most value investors do, then that idea of volatility melts away and, in fact, volatility becomes your friend. Risk then becomes the loss of permanent capital. You can bring these under the same tent by thinking about the temporal dimension.”



  1. “Innovation, especially in America, is continuing at a breakneck pace, even in areas facing substantial political or regulatory headwinds.” Anyone involved in a real business or an occupation like medicine can see the pace of innovation in increasing not decreasing. That people are not buying as much capital equipment like machine tools is not evidence that innovation has slowed. That software is replacing capital goods is obvious to anyone paying attention to the real economy.  Innovation is racing ahead, but not all innovation is profitable. A simple way to think about disruption is to say that it happens when one business is able to harm or eliminate the competitive advantage of another business. It’s that simple. Disruption happens when a business creates innovation which reduces the competitive advantage of rival businesses. Innovation both creates and destroys competitive advantage and therefore profit. Consumers always benefit from innovation. Producers only sometimes benefit from innovation depending on whether the innovation creates or harms a moat.





Ben Graham interview in Medical Economics “The Simplest Way to Select Bargain Stocks” September 1976. Ben Graham interview in Medical Economics “The Simplest Way to Select Bargain Stocks” September 1976.  http://blog.alphaarchitect.com/wp-content/uploads/2011/04/Simple-and-Easy-Approach-Medical-Economics-Graham-1976.pdf


60 Minutes Interview with Burry https://www.youtube.com/watch?v=blq-1pLGKwc


Bloomberg Profile: http://www.hulu.com/watch/333216


Vanity Fair Profile: http://www.vanityfair.com/news/2010/04/wall-street-excerpt-201004


New York Magazine: http://nymag.com/daily/intelligencer/2015/12/#


Wikipedia https://en.wikipedia.org/wiki/Michael_Burry


Bustle profile: http://www.bustle.com/articles/133631-what-is-michael-burry-doing-today-the-big-short-character-is-still-weary-of-the-financial


My post on Taleb:  https://25iq.com/2013/10/13/a-dozen-things-ive-learned-from-nassim-taleb-about-optionalityinvesting/


My post on Greenblatt: https://25iq.com/2015/01/25/a-dozen-things-ive-learned-from-joel-greenblatt-about-value-investing/

Two Powerful Mental Models: Network Effects and Critical Mass

This post is all about network effects and critical mass. But it’s also about applying those concepts as important mental models in business, so I will share a short story about a business decision I once made that required me to consider network effects.


networkeffectsThe Internet bubble had popped by 2002, and a lot of people were looking for the next big thing. One day that summer, my friend told me about the idea behind Friendster, which sounded promising: “system, method, and apparatus for connecting users in an online computer system” (according to patent number 7,069,308).

Friendster was pioneering what would become known as a social network.

By the time I was evaluating this potential investment in 2002, I had become a disciple of Charlie Munger’s “lattice of mental models” approach to making decisions. One of the best descriptions of mental models I’ve seen is Nobel-prize winning social scientist Herbert Simon’s original framing of the concept, where he states that better decision makers have at their disposal repertoires of possible actions; checklists of things to think about before acting; and “mechanisms in mind to evoke these, and bring these to conscious attention when the situations for decision arise.”

So a mental model isn’t a passive framework, it’s something to actively use in making decisions. In each case you must decide not only which mental models to apply, but which ones are most important. Each model is like a different filter or tool. The mental models are applied in parallel and not in a serial, step-by-step way. The process is necessarily analog in nature since in most cases assumptions are rough, the systems involved are complex adaptive systems, and different models can be self-reinforcing. The process is also based on experience: The decision maker is usually applying judgment most often acquired from when he or she made mistakes in the past.

a mental model isn’t a passive framework, it’s something to actively use in making decisions

One of the most important mental models in business is the concept of network effects. This is especially true today, when other factors that can create a moat against competitors — brand, regulation, supply-side economies of scale, and intellectual property (like patents) — are under threat. As software continues to “eat the world,” network effects become even more important as a factor in creating a moat since that’s the primary way software companies build a barrier to entry against competitors. That’s why venture capital firms investing in software-based startups include network effects in the business attributes they are looking for

Nothing scales as well as a software business, and nothing creates a moat for that business more effectively than network effects.

Network effects don’t always lead to direct financial or long-term value, however. For example, a standard like Ethernet generates network effects and benefits that last longer than one would expect for supply-side economies of scale. But Ethernet also illustrates that sometimes no one directly financially benefits from the standard itself (since it is owned by no one). And even if network effects are strong initially, as with DEC, Palm, and BlackBerry — they can be brittle and disappear relatively quickly, as those businesses discovered.

Nothing scales as well as a software business, and nothing creates a moat for that business more effectively than network effects

Network effects as a mental model

Network effects exist when the “value” of a format or system depends on the number of users. These effects can be positive (for example, a telephone network) or negative (for example, congestion). They can also be direct (increases in usage lead to direct increases in value to users, as with the telephone) or indirect (usage increases the production of complementary goods, as with cases for mobile phones). Network effects can protect valuable markets, or not much of a market at all in terms of financial value.

Network effects can exist in settings that are not obvious. Take ESPN for example. It has demand-side economies of scale (aka network effects) — most notably for SportsCenter — since the more people who watch the ESPN channels, the more valuable the channels are to each user because those particular images will be the basis of discussion for sports fanatics. Partly due to those network effects, ESPN has a competitive advantage compared to Fox and other sports channels that have a hard time replicating the demand-side effects. When someone says “did you see X do Y in the Z game?” if you watched the Fox version of SportsCenter, you may not have seen the particular video clip.

In tech, significant market adoption of a proprietary format or system can create a network effect and a competitive advantage for a business that is similar to supply-side economies of scale. But network effects are potentially more powerful. Unlike supply-side economies of scale, the benefits of demand-side economies of scale can increase in a nonlinear manner, especially in software businesses. This means that the benefits realized by a Google are far larger than those realized by a large steel or cement producer based on supply-side economies of scale. Google has at least two beneficial demand-side economies of scale — one for search and one for advertising targeting — that are mutually reinforcing and accordingly give it a strong moat. As Munger has observed: “I’ve probably never seen such a wide moat” and “I don’t know how you displace Google.” Om Malik writes about this winner-take-all dynamic as well.

For the owner of the platform, such as Google in this case, the networks effects form the basis of a powerful moat that bestows sustainable competitive advantage. A company may have revenue without some form of a moat, but it is highly unlikely it will be sustainably profitable over time without one.

Some network effects are strong and some are weak.  For example, Google’s moat in the advertising-serving business is strong. Yahoo’s moat in the financial news market (Yahoo Finance) is very weak. Some markets impacted by multi-sided makers with network effects are big and lucrative (e.g., ESPN or Bloomberg’s terminal business) and some are not (Yahoo Sports).

Some companies have both demand and supply-side economies of scale. Amazon has both, and they reinforce each other. For example, the more people who provide comments on Amazon the more valuable it becomes to other users due to demand-side economies (everybody knows to find reviews on Amazon). Amazon also has huge advantages on warehouses and the supply chain on the supply-side, which it passes along to its customers in the form of lower costs.

In fact, most companies have both supply-side and demand-side economies of scale. However, these fall along a continuum of weak to strong. The Holy Grail for an entrepreneur is demand-side economies of scale that can cause a market to “tip”, giving almost the entire market to one company (winner-takes-all). Markets are more likely to tip if scale economies are high and the consumers have a low demand for variety. At one point, demand for online auctions tipped strongly to eBay. Over time that tipping phenomenon has weakened.

But the reality is that most demand-side economies do not cause a market to “tip” and yield a single winner. For example, the rental car industry has a number of providers since weak demand-side economies in that business were not strong enough to make the market tip.

When applying network effects goes too far

When I was applying the mental model of network effects to the Friendster decision back in 2002, I saw potential for a big financial upside. My experience in the wireless industry led me to conclude that the more people who used Friendster, the more valuable it would become.

But I had just come through the Internet bubble and seen how people had taken the concept of network effects too far — and without sufficient depth — led by “Piped Pipers” of financial doom like George Gilder, who first formulated Metcalfe’s Law. An article by Briscoe, Odlyzko, and Tilly describes the folly:

“By seeming to assure that the value of a network would increase quadratically — proportionately to the square of the number of its participants — while costs would, at most, grow linearly, Metcalfe’s Law gave an air of credibility to the mad rush for growth and the neglect of profitability. It may seem a mundane observation today, but it was hot stuff during the Internet bubble.”

The article goes on to propose that more realistically:

“the value of a network of size n grows in proportion to n log(n). Note that these laws are growth laws, which means they cannot predict the value of a network from its size alone. But if we already know its valuation at one particular size, we can estimate its value at any future size, all other factors being equal…. The fundamental flaw underlying… Metcalfe’s law is in the assignment of equal value to all connections or all groups.”

The point is that the strength of network effects is not just determined by the number of participants in a network. Affinity between participants, and the value of trade between those participants, matters. As the authors of the article referenced above observe, the increasing value “lies somewhere between linear and exponential growth” — and where exactly it fits will vary from case to case, as amusingly shown by this illustration from Serge Block [via Thoughts Illustrated]:


(As an aside, I had found Andrew Odlyzko’s ideas to be particularly useful in the past, most notably when he wrote important papers debunking claims about the rate of Internet growth. For example, it was while reading Odlyzko’s paper in November of 2000 that I realized: “Holy crap, Cisco’s Internet growth numbers are rubbish.”)

the strength of network effects is not just determined by the number of participants in a network

Ultimately, I decided not to invest in Friendster due to potential conflicts in some other work I was doing at the time. But my instincts about it benefitting from network effects turned out to be correct: By June 2003 the service had 835,000 registered members; four months later, there were more than two million.

Yet growth would eventually stall. And Friendster would be overtaken first by MySpace and then conclusively by Facebook. Why?

Critical mass as a related mental model

There are a number of autopsies written about what went wrong with Friendster. The only thing they really share in common is that they are all guesses about the outcome of complex adaptive systems. So opinions on “what happened to Friendster” are like belly buttons — everyone has one, and they are all different. Wired magazine summarizes the conclusion of one opinion, citing David Garcia, a professor with the Swiss Federal Institute of Technology:

“What they found was that by 2009, Friendster still had tens of millions of users, but the bonds linking the network weren’t particularly strong. Many of the users weren’t connected to a lot of other members, and the people they had befriended came with just a handful of their own connections. So they ended up being so loosely affiliated with the network, that the burden of dealing with a new user interface just wasn’t worth it. ‘First the users in the outer cores start to leave, lowering the benefits of inner cores, cascading through the network towards the core users, and thus unraveling,’ Garcia told us.”

Garcia raises an important issue related to network effects here, though: that of critical mass, which is yet another mental model.

The term “critical mass” came into use around 1941 though it originally had a very limited definition: the minimum amount of a given fissionable material necessary to sustain a nuclear chain reaction at a constant rate. While not the first to use the term in a physics setting, the physicist Leo Szilard is said to be the first person to propose that a chain reaction could be created starting from a critical mass of uranium. And that’s the critical point behind the concept as we apply it today.

Soon, other disciplines began to use the term “critical mass” as a mental model. One of the first people to apply it to the social sciences was the same person who created the mental models construct — Herbert Simon. His influential essay on critical mass, “Bandwagon and underdog effects and the possibility of election predictions”, was published in 1954. (Simon later went on to win the Nobel Prize “for his pioneering research into the decision-making process within economic organizations”.)

Other definitions of critical mass exist for other disciplines. In business, critical mass refers to “the size a company needs to reach in order to efficiently and competitively participate in the market. This is also the size a company must attain in order to sustain growth and efficiency.” In a technology business, critical mass refers to the level of users that are required to help create a set of network effects that are so strong, that they build a moat for that particular business. Sometimes there is no second place in a market when network effects are that strong.

Critical mass is present in a platform business if a sufficient number of users adopt an innovation in a system so that adoption of those innovations becomes self-reinforcing. The classic example people cite to illustrate this point was the competition between the Beta and VHS videocassette formats in the 1970s. Beta was considered to be the superior format in terms of quality but VHS reached critical mass first. A research paper by Sangin Park notes:

“The tipping and de facto standardization of the VHS format in 1981-1988 is believed to have been caused by network externalities [aka network effects]. In the time period, watching prerecorded videotapes such as movie titles became the most important reason to use VCRs. Hence an increase in the users of VHS VCRs could raise a variety of available movie titles and thus the demands for VHS VCRs. That is, indirect network externalities became signification in the home VCR market.”

Getting to critical mass when creating a multi-sided market is sometimes called overcoming the “chicken and egg problem”, which can be stated simply as: How do you get one side to be interested in a platform until that other side exists (and vice versa)? How did someone sell the first ever fax machine when there was no one on the other end to receive the fax yet? (Obviously that salesperson had to sell at least two machines.)

But in the case of complements that are different — such as game developers making games for Sony consoles before there were even a lot of consoles out there — how do you get one side (developers or console buyers) on board in the first place? In Sony’s case, it sold game consoles at a loss to build up a base of users that would attract developers. As with all network effects, this eventually resulted in a flywheel effect where enough developers made enough games to attract enough users (players) which in turn attracted more developers and thus resulted in more games for more those players and a stronger user base for developers and so on.

How do you get one side to be interested in a platform until that other side exists?

What happens if a market does “tip”… but it’s the competitor that reaps those benefits? Well, that’s what happened to MySpace with Facebook. MySpace started to monetize before the social networking market “tipped”. Facebook held off monetizing until its moat was secure. Zuckerberg was patient about waiting for the market to tip whereas Rupert Murdoch was not. So MySpace paid the price and Facebook reaped the rewards.

Some mental models should be weighted more than others

The mental models approach is simpler than it seems. There are about 100 important mental models (which come from multiple disciplines) that a person should use. “Fortunately,” as Munger says, “it isn’t that tough because 80 or 90 important models will carry about 90% of the freight in making you a worldly wise person. And, of those, only a mere handful really carry very heavy freight.”

I’d argue that network effects and critical mass are two of these mental models that carry a lot of weight.

You do not need to know every mental model or even know them all deeply to make better decisions, but you do need to understand how most of them work at a basic level at least. Speaking about that importance of balancing depth vs. breadth, Charlie Munger recently said “The trouble is you make terrible mistakes everywhere else without [extreme specialization], so synthesis should be a second attack on the world after specialization. It is defensive, and it helps one to not be blindsided by the rest of world.”

In business, specialization helps acquire comparative advantage. But not being wise can bite you in the rear end.

The application of a mental model from physics to other disciplines – as well as business or life questions — is intended to be a method of improving general thought. But it’s pure folly to assume that formulas from physics can be applied in human affairs and produce the same predictive outcomes. As Richard Feynman says, electrons do not have feelings like people. The real world — which is a nest of complex systems — can’t be modeled like a physical system. The trick is to apply the basic ethos of physics in your metal model without assuming that the real world can be modeled with formulas containing Greek letters.

Ultimately, the goal is to use mental models — like network effects and critical mass — to increase the probability of correct decisions. It is far better to be roughly right rather than to be precisely wrong in doing so.

12 x 2 quotes on network effects and critical mass

Network effects

1. “When the value of a product to one user depends on how many other users there are, economists say that this product exhibits network externalities, or network effects.” Carl Shapiro and Hal Varian

2. “A network effect exists when the value of a good increases because the number of people using the good increases. All things being equal, it’s better to be connected to a bigger network than to a smaller one. Adding new customers typically makes the network more valuable for all participants because it increases the probability that everyone will find something that meets their needs. So getting big fast matters, not only because it creates more value, but also because it assures that competing networks never take hold.” Michael Mauboussin

3. “Network effects are tricky and hard to describe but fundamentally turn on the following question: Can the marketplace provide a better experience to customer “n+1000” than it did to customer “n” directly as a function of adding 1000 more participants to the market? You can pose this question to either side of the network – demand or supply. If you have something like this in place it is magic, as you will get stronger over time not weaker.” Bill Gurley

4. “Businesses [can] create barriers to entry through “network effects”, in which the value of a service to a user increases as others use it. This can potentially arise in a number of ways: for example a proprietary data asset; the marketplace dynamics of having a robust set of sellers and buyers; or through the development of a community that openly shares and exchanges information. In an era where the initial cost to develop the prototype of a product has been dramatically reduced, where there are mature and scalable open source tools and services to utilize for that development, and where cloud infrastructure is available on demand and at a variable cost, defensibility may no longer be found in the technology underpinnings — the code or IP — of a service. Defensibility may however arise through the growth of service that gets more valuable, and more interesting, with each new participant.” Union Square Ventures

5. “A popular strategy for bootstrapping networks is what I like to call ‘come for the tool, stay for the network.’ The idea is to initially attract users with a single-player tool and then, over time, get them to participate in a network. The tool helps get to initial critical mass. The network creates the long term value for users, and defensibility for the company.” Chris Dixon

6. “Network effects can be powerful, but you’ll never reap them unless your product is valuable to its very first users when the network is necessarily small….Paradoxically, then, network effects businesses must start with especially small markets. Facebook started with just Harvard students–Mark Zuckerberg’s first product was designed to get all his classmates signed up, not to attract all people of Earth. This is why successful network businesses rarely get started by MBA-types: the initial markets are so small that they often don’t even appear to be business opportunities at all.”  Peter Thiel

7. “…there are what I call groove-in effects tied to customers and consumers. Basically, this means that the more I use a product, the more I’m familiar with that product, the more convenient it gets for me. I use Microsoft Word. There might be a better program out there, but I know all the tricks with Word that I mastered over several years and I am very reluctant to give that up to start over with another product.” Brian Arthur

8. “The answer [to creating a flywheel] lies in two essential variables: the size of the market and the strength of the value proposition. Any growth goes through an exponential curve, then flatters with saturation. If the ceiling of the market opportunity is $200 million, even if you get a flywheel, it will take you from twenty to sixty or seventy, then peter out because you saturated the available space. The bigger the market the more runway you have — so if you hit that knee of the curve, you can grow exponentially and keep going for a long time. Doubling a business of material size for three to four years leads to a really large, important company. That’s a key element in the flywheel idea.” Roelof Botha

9. “In marketplace businesses, sell-through rate can also go by “close rate”, “conversion rate”, and “success rate”. Regardless of what it’s called, sell-through rate is one of the single most important metrics in a marketplace business. As investors, we like to see a relatively high rate so that suppliers are seeing good returns on the effort they put into posting listings on the marketplace. We also like to see this ratio improving over time, particularly in the early stages of marketplace development (as it often indicates developing network effects).” Andreessen Horowitz, 16 Metrics

10. “Because the long-run success of a song depends so sensitively on the decisions of a few early-arriving individuals, whose choices are subsequently amplified and eventually locked in by the cumulative-advantage process, and because the particular individuals who play this important role are chosen randomly and may make different decisions from one moment to the next, the resulting unpredictably is inherent to the nature of the market. It cannot be eliminated either by accumulating more information — about people or songs — or by developing fancier prediction algorithms, any more than you can repeatedly roll sixes no matter how carefully you try to throw the die.” Duncan Watts

11. “Ultimately, we’re all social beings, and without one another to rely on, life would be not only intolerable but meaningless. Yet our mutual dependence has unexpected consequences, one of which is that if people do not make decisions independently — if even in part they like things because other people like them — then predicting hits is not only difficult but actually impossible, no matter how much you know about individual tastes. The reason is that when people tend to like what other people like, differences in popularity are subject to what is called “cumulative advantage,” or the “rich get richer” effect. This means that if one object happens to be slightly more popular than another at just the right point, it will tend to become more popular still. As a result, even tiny, random fluctuations can blow up, generating potentially enormous long-run differences among even indistinguishable competitors — a phenomenon that is similar in some ways to the famous “butterfly effect” from chaos theory.” Duncan Watts

12. “Network effects can be classified along a spectrum, with stronger and weaker forms.” Michael Mauboussin

Critical mass

1. “The notion of a critical mass — that comes out of physics — is a very powerful model.” “Adding success factors so that a bigger combination drives success, often in non-linear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result. And of course I’ve been searching for lollapalooza results all my life, so I’m very interested in models that explain their occurrence. An extreme of good performance over many factors.” Charlie Munger

2. “We don’t have automatic competitive advantages. We’re seeing some more insurance volume, mainly from General Re, and Cort and Precision Steel have momentum, but we have to find future advantages through our own intellect. We don’t have enough critical mass and momentum in place at Wesco, so investors are betting on management.” Charlie Munger. He is saying that he does not like a situation where he does not have critical mass in the business or businesses he controls and that sometimes we must rely on having better management. He would prefer to have business that even an idiot can run successfully but sometimes that is not the case.

3. “There will be certain points of time when everything collides together and reaches critical mass around a new concept or a new thing that ends up being hugely relevant to a high percentage of people or businesses. But it’s really really hard to predict those. I don’t believe anyone can.” Marc Andreessen

4. “One clear lesson in the history of technology and business is that once an open standard gains critical mass, it is extremely hard to derail. The x86 computing architecture and the Ethernet networking standard are two salient examples of this truism. Once a single inter-operable standard gains the acceptance of multiple vendors in a marketplace, a consumer bias toward compatibility and scale economics create an increasing returns phenomenon that is nearly unassailable.” Bill Gurley

5. “Economies of scope and agglomeration are obtained by the presence of a critical mass of consumers…. Using a chemistry analogy, we hypothesize that (see Stuart Kaufman and Brian Arthur), a critical mass of consumers and producers, a ‘soup’ with sufficient diversity of consumers, producers, ideas, skills, at a sufficient scale and critical mass will become autocatalytic. Economic activity, newly catalyzed business activity, and other surprise will emerge. Emergent behavior, surprising and unplanned, is a well-known behavior of complex systems and a manifestation of the invisible hand of Adam Smith.” Vinod Khosla

6. A tipping point is “the moment of critical mass, the threshold, the boiling point.” Malcolm Gladwell

7. “Phase transitions are unusual points in the ‘phase space’ of possible states, while most of this space is occupied by stable states.” “There seem to be ‘laws’ [of] social systems that have at least something of the character of natural physical laws, in that they do not yield easily to planned and arbitrary interventions. Over the past several decades, social, economic and political scientists have begun a dialogue with physical and biological scientists to try to discover whether there is truly a ‘physics of society’, and if so, what its laws and principles are. In particular, they have begun to regard complex modes of human activity as collections of many interacting ‘agents’ — somewhat analogous to a fluid of interacting atoms or molecules, but within which there is scope for decision-making, learning and adaptation.” Philip Ball

8. “At a certain scale, a system reaches a critical mass or a limit where the behavior of the system may change dramatically. It may work better, worse, cease to work or change properties. Small interactions over time slowly accumulate into a critical state — where the degree of instability increases. A small event may then trigger a dramatic change like an earthquake. A small change may have no effect on a system until a critical threshold is reached. For example, a drug may be ineffective up until a certain threshold and then become effective, or it may become more and more effective, but then become harmful. Another example is from chemistry. When a system of chemicals reaches a certain level of interaction, the system undergoes a dramatic change. A small change in a factor may have an unnoticeable effect but a further change may cause a system to reach a critical threshold making the system work better or worse. A system may also reach a threshold when its properties suddenly change from one type of order to another. For example, when a ferromagnet is heated to a critical temperature it loses its magnetization. As it is cooled back below that temperature, magnetism returns.” Peter Bevelin

9. “Silicon Valley has evolved a critical mass of engineers and venture capitalists and all the support structure — the law firms, the real estate, all that — that are all actually geared toward being accepting of startups.” Elon Musk

10. “Startups with a customer base need to maintain an ongoing dialog with their customers — not make a set of announcements when the founder thinks it’s time for something new. This is why entrepreneurship is an art. When you have a critical mass of customers, there’s a fine line between sticking with the status quo too long and changing too abruptly.” Steve Blank

11. “If you tell Facebook about your startup before you reach critical mass, you are an idiot.” Jason Calacanis

12. “Critical Mass.” Dr. Evil



This post was syndicated by permission of the author. About the author: Tren Griffin’s professional background has primarily involved areas where business meets technologies like software and mobile communications. He currently works at Microsoft. Previously, he was a partner at private equity firm Eagle River (established by Craig McCaw) and before that, a consultant in Asia. Griffin’s latest book, Charlie Munger: The Complete Investor is about the legendary Berkshire Hathaway vice chairman, and how he invokes a set of interdisciplinary “mental models” involving economics, business, psychology, ethics, and management to keep emotions out of his investments and avoid the common pitfalls of bad judgment. 

notes and sources

Describing People as Particles Isn’t Always a Bad Idea http://nautil.us/issue/33/attraction/describing-people-as-particles-isnt-always-a-bad-idea

Metcalfe’s Law is Wrong

A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business https://old.ycombinator.com/munger.html

Is Justin Timberlake a Product of Cumulative Advantage? http://www.nytimes.com/2007/04/15/magazine/15wwlnidealab.t.html

Sangin Park: Strategic Maneuvering and Standardization: Critical Advantage or Critical Mass? http://repec.org/esFEAM04/up.4969.1080375989.pdf

All Markets Are Not Created Equal: 10 Factors To Consider When Evaluating Digital Marketplaces

Investment Thesis at USW

Essays on Network Effects

16 More Startup Metrics

Dynamic Oligopoly with Network Effects http://www.stern.nyu.edu/networks/Dynamic_Duopoly_with_Network_Effects.pdf

An Interview with W. Brian Arthur

A Conversation with Three Scientists

Philip Ball Critical Mass

The Innovator’s Ecosystem

The Rise of Open-Standard Radio: Why 802.11 is Under-Hyped http://abovethecrowd.com/2004/02/02/the-rise-of-open-standard-radio-why-80211-is-under-hyped

A Dozen Things I’ve Learned from @pmarca

Notes for a history of the critical mass model

Critical Mass

Critical Mass Investopedia

Critical Mass Wikipedia

What Ever Happened to Critical Mass Theory http://www.uvm.edu/~pdodds/files/papers/others/2001/oliver2001.pdf

Latticework of Mental Models: Critical Mass

A Dozen Things I’ve Learned from Benjamin Franklin About Money and Investing


Benjamin Franklin was an amazing person measured by any standard. His story is worth learning about in detail and there are some wonderful biographies available. It is hard to do justice to Franklin’s accomplishments and his life story in a a blog post, but here is a highly simplified summary of the basics:

“Franklin was born in Boston in 1706. He was legally indentured to work in his brother’s print shop when he was 12 years old, and he did so until he turned 17. Then Franklin skipped Boston for Philadelphia, where he became a successful printer and writer. He [founded] Philadelphia’s first lending library, first fire department, and first post office. He was always active in colonial politics. Along the way, he became a world-famous scientist. He served as Pennsylvania’s colonial regent in England from 1757 to 1762. Franklin helped draft both the Declaration of Independence and the Constitution.”

“Franklin started the American Philosophical Society, which was this country’s first scientific society and maintained the first science library, first museum, and first patent office; more than 90 members of this society went on to win Nobel Prizes. On his eight trans-Atlantic crossings, Franklin made measurements that helped chart the Gulf Stream. He pioneered the study of water flowing around a hull—hydrodynamics. He investigated meteorology. He invented bifocal spectacles. He was most famous, of course, for his experiments with electricity, especially lightning. His lightning rod helped banish the terror of thunderstorms.”

Franklin is a hero to many people including Charlie Munger:

“There is the sheer amount of Franklin’s wisdom… And the talent. Franklin played four instruments. He was the nation’s leading scientist and inventor, plus a leading author, statesman, and philanthropist. There has never been anyone like him…. Franklin was quite old when he was ambassador to France. This was after he was world famous and rich, and he was more self-indulgent than when he was young and making his way in the world. But he was a very good ambassador and whatever was wrong with him from John Adams’s point of view helped him with the French. I think Franklin was a marvelous steward. I’m willing to take the fellow as he averaged out. And certainly I’m in favor of old people having a little enjoyment.”

As is usual, the dozen quotes from Ben Franklin follow in bold text:

1. “In 1732 I first published my Almanack under the name of Richard Saunders; it was continued by me about twenty-five years, and commonly called Poor Richard’s Almanack. I endeavoured to make it both entertaining and useful, and it accordingly came to be in such demand, that I reaped considerable profit from it, vending annually near ten thousand.” Franklin learned the printing trade working for his brother and including time he later spent in London working for other printers. As the story goes:

“At length the harmony between himself and brother was interrupted, and he left his service and went on board a vessel in the harbor, bound for New York. In that city he could not obtain employment, and he proceeded on foot to Philadelphia, where he arrived on a Sabbath morning. He was then but seventeen years old, friendless and alone, with but a single dollar in his pocket… It is said that his first appearance in Philadelphia attracted considerable attention in the streets. With his spare clothing in his pocket, and a loaf of bread under each arm, he wandered about until he came to a Quaker meeting, where he entered, sat down, went to sleep, and slept soundly until worship was closed.”

Franklin, who started his business with very little capital, needed to generate customers in a cost-effective way. He found his solution in the form of what today would be called “content marketing.” It has been argued that Benjamin Franklin was the first American and it can similarly be argued that he was the first American content marketer. By printing and distributing his Poor Richard’s Almanack Franklin was able to spread the word about his business and acquire a reasonable customer acquisition cost (CAC) in relation to the revenue his business could generate from that customer. Franklin’s book was published before other content marketing efforts like August Oetker’s cookbooks promoting Backin baking powder (1891) or John Deere’s magazine, The Furrow. Franklin’s advice for others following in his footsteps was simple and to the point: “Either write something worth reading or do something worth writing.” It is an interesting exercise to keep track of what you read during a day and think about how much of what you read on a daily basis is content marketing. There is so much content marketing that it is crowding out other forms of writing with different business models. Why read a book when you can read a blog for free, especially if that blog maps to the typical attention span of about six minutes? Would Poor Richard’s Almanack today be a blog offered for free as part of a freemium business model?

2. “An investment in knowledge always pays the best interest.” Buffett has made a similar point to the one being made by Franklin in the previous quote. Buffet said: “Generally speaking, investing in yourself is the best thing you can do. Anything that improves your own talents; nobody can tax it or take it away from you. They can run up huge deficits and the dollar can become worth far less. You can have all kinds of things happen. But if you’ve got talent yourself, and you’ve maximized your talent, you’ve got a tremendous asset that can return ten-fold.” Through self-directed reading and self-education Franklin turned himself into an “expert generalist” which I wrote about in my previous blog post. Franklin said: “This library afforded me the means of improvement by constant study, for which I set apart an hour or two each day, and thus repaired in some degree the loss of the learned education my father once intended for me. Reading was the only amusement I allowed myself. I spent no time in taverns, games, or frolics of any kind; and my industry in my business continued as indefatigable as it was necessary.”

3. “Money is of a prolific generating Nature. Money can beget Money, and its Offspring can beget more, and so on. Five Shillings turn’d, is Six: Turn’d again, ’tis Seven and Three Pence; and so on ’til it becomes an Hundred Pound. The more there is of it, the more it produces every Turning, so that the Profits rise quicker and quicker.” Franklin understood that not only is compound interest powerful, but “cumulative advantage” is a highly advantageous phenomenon. Success in almost any domain inevitably creates more success as the process feeds back on itself. The classic essay on this is from Duncan Watts entitled: “Is Justin Timberlake a Product of Cumulative Advantage” (find a link to this essay in the notes). In my blog post on Julian Robertson I wrote:

“The basic idea is that once a person or business gains a small advantage over others, that advantage will compound over time into an increasingly larger advantage. This is sometimes called ‘the rich get richer and the poor get poorer’ or ‘the Matthew effect’ based on a biblical reference. Merton used this cumulative advantage concept to explain advancement in scientific careers, but it is far broader in it application. Cumulative advantage operates as a general mechanism which increases inequality and explains why wealth and incomes follow a power law.”

4. “If a Man lets his Money lie in my Hands after it is due, he gives me the Interest, or so much as I can make of it during that Time. This amounts to a considerable Sum where a Man has good and large Credit, and makes good Use of it.” Franklin understood the financial value of what is called “float,” which Buffett once described as “free money — and, better yet, getting paid for holding it.” Buffett has also said: “Float is money that doesn’t belong to us but that we temporarily hold. Float is wonderful – if it doesn’t come at a high price.” On float Charlie Munger has said:

“Growing float at a sizeable rate at low cost is almost impossible — but we intend to do it anyway.”

“I’ve been amazed by the growth and cost of our float. It’s wonderful to generate billions of dollars of float at a cost way below Treasury notes.”

“We were always opportunistic and wanted to buy the best thing conveniently available that we could understand. Early on, we looked a lot at float businesses in the public markets, but nowadays we have so much float it isn’t as useful, and Europe and Japan rates are negative, so we can’t get great returns on the cash that the float gives us. We made so much money off those float businesses it was obscene.”

It is interesting that both Buffett and Munger have said that the ability to profit from float in the insurance business is not what it used to be. Carol Loomis has written: “Float has been rising at Berkshire for eons, but Buffett began a couple of years ago to warn that future gains would be tough to get. But still they’ve kept coming.” One way to look at the importance of float is to use the inversion approach. For example, as Buffett does here:  “[Depreciation] is reverse float — you lay out money before you get cash. Any management that doesn’t regard depreciation as an expense is living in a dream world.”

5. “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” The other way to put this is that nothing is certain except risk, uncertainty and ignorance. Michael Mauboussin describes the right taxonomy well by saying: “Risk is when we don’t know what the outcome is going to be, but we do know the definable distribution… Uncertainty, by contrast, is when we don’t know what the outcome is, but we actually don’t know what the underlying distribution looks like.” Ignorance exists when you do not even know the potential outcome is possible or can’t even conceive of it. As is that case with many of Franklin’s axioms, it is unlikely that Franklin was the first person make the point in the quotation, but was unique in his phrasing. For example, the Yale Book of Quotations quotes “Tis impossible to be sure of any thing but Death and Taxes,” from Christopher Bullock, The Cobler of Preston (1716) and also quotes “Death and Taxes, they are certain,” from Edward Ward, The Dancing Devils (1724). Daniel Defoe The Political History of the Devil 1726 wrote: “Things as certain as Death and Taxes, can be more firmly believ’d.”

6. “Success has ruined many a man.” This Franklin phrase was probably borrowed from Samuel Richardson:

“In great Prosperity, as well as in great Calamity, we ought to look into ourselves, and fear. Success has blown up, and undone many a man. Who is there that Wealth does not mislead? Prosperity sets up merit as a mark for envy to shoot its shafts at. The greatly Prosperous bear controul and disappointments with difficulty. Great acquirements are great snares.”

Mark Twain wrote about Franklin and his borrowing of the writing of others:

“Franklin the immortal axiom-builder, who used to sit up at nights reducing the rankest old threadbare platitudes to crisp and snappy maxims that had a nice, varnished, original look in their regimentals; who said, “Virtue is its own reward;” who said, “Procrastination is the thief of time;” who said, “Time and tide wait for no man” and “Necessity is the mother of invention;” good old Franklin, the Josh Billings of the eighteenth century–though, sooth to say, the latter transcends him in proverbial originality as much as he falls short of him in correctness of orthography. What sort of tactics did Franklin pursue? He pondered over his last words for as much as two weeks, and then when the time came, he said, ‘None but the brave deserve the fair,” and died happy. He could not have said a sweeter thing if he had lived till he was an idiot.’”

Franklin believed that a person should try to avoid hubris. You should also try to avoid fooling yourself, which is hard since it is easy to do. If you understand that more of success in life is luck than you imagine it is easier to remain humble. Many people attribute what is really luck to skill and then assign themselves an undeserved moral halo. That someone has become rich does not always correlate well to whether they have anything valuable to say.

7. “Necessity never made a good bargain.” The best negotiating position exists when you have what Roger Fisher called a BATNA (best alternative to negotiated agreement) in his best-selling book Getting to Yes. In short, it is your alternatives that matter. Without some alternative to what you seek in the negotiation the other negotiator has a very strong  lever to get what they want. This is really just simple opportunity cost thinking.

8. “A penny saved is a penny earned.” “Rather go to bed without dinner than to rise in debt.” “Think what you do when you run in debt; you give to another power over your liberty.” “If you would know the value of money, go and try to borrow some; for he that goes a borrowing goes a sorrowing.” “The Way to Wealth, if you desire it, is as plain as the Way to Market. It depends chiefly on two Words, INDUSTRY and FRUGALITY; i.e. Waste neither Time nor Money, but make the best Use of both.” “Beer is living proof that God loves us and wants us to be happy.” Franklin worked hard and read widely to populate the pages of his books and other writings. As was previously stated, did he borrow from people who came before him? Sure. But by any standard Franklin gave us vastly more than he borrowed. We all stand on the shoulders of giants. Mark Twain humorously said that he resented Franklin’s example since the principles he talked and wrote about were used in Twain’s upbringing:

“If it had not been for him, with his incendiary ‘Early to bed and early to rise,’ and all that sort of foolishness, I wouldn’t have been so harried and worried and raked out of bed at such unseemly hours when I was young. With a malevolence which is without parallel in history, he would work all day, and then sit up nights, and let on to be studying algebra by the light of a smoldering fire, so that all other boys might have to do that also, or else have Benjamin Franklin thrown up to them. Not satisfied with these proceedings, he had a fashion of living wholly on bread and water, and studying astronomy at meal time–a thing which has brought affliction to millions of boys since, whose fathers had read Franklin’s pernicious biography.”

9. “Time is money. He that can earn Ten Shillings a Day by his Labour, and goes abroad, or sits idle one half of that Day, tho’ he spends but Sixpence during his Diversion or Idleness, ought not to reckon That the only Expence; he has really spent or rather thrown away Five Shillings besides.” The phrase “time is money” was used by Franklin in a 1746 essay entitled Advice to a Young Tradesman, Written by an Old One (an essay reproduced in full in the notes). The key point being made again by Franklin here is that it is wise to think in terms of opportunity cost. How early was Franklin in making points related to opportunity cost?  Frédéric Bastiat did not write his essay What is Seen and What is not Seen until 1848. David Ricardo’s writing on the importance of comparative advantage and opportunity cost did not appear until the early 1800s. Combine this quotation with Franklin advancing ideas like (1) “no nation was ever ruined by trade” and his essays on  “paper money” when he was only 23 years old and an argunet can be made that Franklin was a pioneering economic thinker too. Was Franklin the first American economist?  Why not? Historical accounts say that Adam Smith sent chapters of his book The Wealth of Nations to Franklin for comments while they both were in London and the two men certainly met and discussed the ideas in the book. One writer notes that: “During [Franklin’s] sojourn of five years in England he had made many valuable friends outside of court and political circles, among whom David Hume and Adam Smith were conspicuous.”

10. “If everyone is thinking alike, then no one is thinking.” Franklin knew that if you adopt a contrarian view and are right about that view, you can both profit and create innovation. Being a contrarian doesn’t produce anything valuable if you are wrong. Thinking is required. Bill Gurley has put it this way: “Being ‘right’ doesn’t lead to superior performance if the consensus forecast is also right.” Michael Mauboussin describes the goal:

“the simple act of being a contrarian will make no one rich. In fact, conforming generally makes the most strategic sense. If you’re in a theatre that catches on fire, you’re best served running out in contrast to the contrarian tack of running into the theatre. If being different is not the sole goal, what should the aspiring contrarian focus on? Here I turn to a common sense distinction that I would argue is the single most common error in the investment business: failure to distinguish between the fundamentals of the situation (of a company in the case of stocks) and the expectations reflected in the asset price. Horse racing provides a good metaphor. There are two issues: how well the horse will likely run – you look at the horse’s record, the stable it came from, the jockey, the track conditions, etc – and the expectations, which show up as the odds posted on the board. A contrarian investor focuses not only on the general sentiment, but more importantly on how that sentiment can lead to disconnects between the fundamentals and market expectations.

11. “Money has never made man happy, nor will it, there is nothing in its nature to produce happiness. The more of it one has the more one wants.” “He that is of the opinion money will do everything may well be suspected of doing everything for money.” What is as interesting as anything about Franklin is that he worked hard to become wealthy and then retired at age 42 and use his wealth to do what he wanted. Charlie Munger is said to have used both Franklin and Robinson Crusoe as a model for the value of being independent. What Munger strove for with his investing was accumulating enough wealth to enable his independence, so he could spend as much time reading and learning as he wanted. In the case of Franklin:

“His printing business made him a wealthy man. But by the age of 42, he had as much money as he needed. He found an able managing partner in whose hands he put the business, and he retired to study philosophy. And philosophy in those days, of course, encompassed science and the general study of the natural world. He thought that was a better use of his time at that point.”

On the topic of wealth, the National Humanities Center notes:

“Franklin is well-known for his aphorisms—usually printed in his almanacs and public essays—promoting frugality, hard work, and plain living as the road to success. This does not mean that Franklin was opposed to wealth in itself, nor that his later acquisition of luxury goods was hypocritical. What mattered to Franklin was how one achieved wealth (honestly) and how one displayed it (unostentatiously).”

12. “When I was a child of seven years old, my friends, on a holiday, filled my pocket with coppers. I went directly to a shop where they sold toys for children; and being charmed with the sound of a whistle, that I met by the way in the hands of another boy, I voluntarily offered and gave all my money for one. I then came home, and went whistling all over the house, much pleased with my whistle, but disturbing all the family. My brothers, and sisters, and cousins, understanding the bargain I had made, told me I had given four times as much for it as it was worth; put me in mind what good things I might have bought with the rest of the money; and laughed at me so much for my folly, that I cried with vexation; and the reflection gave me more chagrin than the whistle gave me pleasure. This, however, was afterwards of use to me, the impression continuing on my mind; so that often, when I was tempted to buy some unnecessary thing, I said to myself, Don’t give too much for the whistle; and I saved my money. As I grew up, came into the world, and observed the actions of men, I thought I met with many, very many, who gave too much for the whistle. When I saw one too ambitious of court favor, sacrificing his time in attendance on levees, his repose, his liberty, his virtue, and perhaps his friends, to attain it, I have said to myself, this man gives too much for his whistle. When I saw another fond of popularity, constantly employing himself in political bustles, neglecting his own affairs, and ruining them by that neglect, “He pays, indeed,” said I, “too much for his whistle.” If I knew a miser, who gave up every kind of comfortable living, all the pleasure of doing good to others, all the esteem of his fellow-citizens, and the joys of benevolent friendship, for the sake of accumulating wealth, “Poor man,” said I, “you pay too much for your whistle.” When I met with a man of pleasure, sacrificing every laudable improvement of the mind, or of his fortune, to mere corporeal sensations, and ruining his health in their pursuit, “Mistaken man,” said I, “you are providing pain for yourself, instead of pleasure; you give too much for your whistle.” If I see one fond of appearance, or fine clothes, fine houses, fine furniture, fine equipages, all above his fortune, for which he contracts debts, and ends his career in a prison, “Alas!” say I, “he has paid dear, very dear, for his whistle.” When I see a beautiful sweet-tempered girl married to an ill-natured brute of a husband, “What a pity,” say I, “that she should pay so much for a whistle!” In short, I conceive that great part of the miseries of mankind are brought upon them by the false estimates they have made of the value of things, and by their giving too much for their whistles.” Franklin is saying in this parable that too much focus on acquiring things (materialism) can result in a lower quality of life. Materialism, jealously and other dysfunctional emotions can cause you to pay too much for anything. Franklin again is talking about opportunity cost. Of course, the hard question is: how much is too much? Franklin did work hard to become wealthy but he used that wealth to create financial freedom for himself to do what he wanted in life. The wealth from his business enabled him to contribute to society and become one of the greatest Americans who ever lived, if not one of the greatest humans who ever lived.


Franklin bio (by Gordy): http://www.legendsofamerica.com/ah-benjaminfranklin.html

Mike Volpi on Franklin: http://fortune.com/2011/03/31/ben-franklin-and-the-art-of-business-development/

Franklin as a Marketer http://www.pbs.org/benfranklin/l3_wit_master.html

Van Doren’s Franklin bio: http://www.amazon.com/Benjamin-Franklin-Volume-Carl-Doren/dp/193154185X

Isaacson’s Franklin bio http://www.amazon.com/gp/product/074325807X/ref=pd_lpo_sbs_dp_ss_1?pf_rd_p=1944687722&pf_rd_s=lpo-top-stripe-1&pf_rd_t=201&pf_rd_i=193154185X&pf_rd_m=ATVPDKIKX0DER&pf_rd_r=0GSFY00H4GNR33JN67X1

Bio of Franklin by Brands: http://www.amazon.com/gp/product/0385495404/ref=pd_lpo_sbs_dp_ss_2?pf_rd_p=1944687722&pf_rd_s=lpo-top-stripe-1&pf_rd_t=201&pf_rd_i=193154185X&pf_rd_m=ATVPDKIKX0DER&pf_rd_r=0GSFY00H4GNR33JN67X1

NNDB Franklin bio: http://www.nndb.com/people/578/000026500/

Good Reads – Franklin Quotes: https://www.goodreads.com/author/quotes/289513.Benjamin_Franklin

Essays: http://nationalhumanitiescenter.org/pds/becomingamer/economies/text4/franklinwealth.pdf

Duncan Watts: http://www.nytimes.com/2007/04/15/magazine/15wwlnidealab.t.html?pagewanted=all&_r=0

Loomis: http://fortune.com/2016/02/27/berkshire-hathaway-buffett-2015-earnings/

National Humanities Center:  http://nationalhumanitiescenter.org/pds/becomingamer/economies/text4/text4read.htm

To my Friend A. B.
As you have desired it of me, I write the following Hints, which have been of Service to me, and may, if observed, be so to you.
Remember that TIME is Money. He that can earn Ten Shillings a Day by his Labour, and goes abroad, or sits idle one half of that Day, tho’ he spends but Sixpence during his Diversion or Idleness, ought not to reckon That the only Expence; he has really spent or rather thrown away Five Shillings besides.
Remember that CREDIT is Money. If a Man lets his Money lie in my Hands after it is due, he gives me the Interest, or so much as I can make of it during that Time. This amounts to a considerable Sum where a Man has good and large Credit, and makes good Use of it.
Remember that Money is of a prolific generating Nature. Money can beget Money, and its Offspring can beget more, and so on. Five Shillings turn’d, is Six: Turn’d again, ’tis Seven and Three Pence; and so on ’til it becomes an Hundred Pound. The more there is of it, the more it produces every Turning, so that the Profits rise quicker and quicker. He that kills a breeding Sow, destroys all her Offspring to the thousandth Generation. He that murders a Crown, destroys all it might have produc’d, even Scores of Pounds.
Remember that Six Pounds a Year is but a Groat a Day. For this little Sum (which may be daily wasted either in Time or Expence unperceiv’d) a Man of Credit may on his own Security have the constant Possession and Use of an Hundred Pounds. So much in Stock briskly turn’d by an industrious Man, produces great Advantage.
Remember this Saying, That the good Paymaster is Lord of another Man’s Purse. He that is known to pay punctually and exactly to the Time he promises, may at any Time, and on any Occasion, raise all the Money his Friends can spare. This is sometimes of great Use: Therefore never keep borrow’d Money an Hour beyond the Time you promis’d, lest a Disappointment shuts up your Friends Purse forever.
The most trifling Actions that affect a Man’s Credit, are to be regarded. The Sound of your Hammer at Five in the Morning or Nine at Night, heard by a Creditor, makes him easy Six Months longer. But if he sees you at a Billiard Table, or hears your Voice in a Tavern, when you should be at Work, he sends for his Money the next Day. Finer Cloaths than he or his Wife wears, or greater Expence in any particular than he affords himself, shocks his Pride, and he duns you to humble you. Creditors are a kind of People, that have the sharpest Eyes and Ears, as well as the best Memories of any in the World.
Good-natur’d Creditors (and such one would always chuse to3 deal with if one could) feel Pain when they are oblig’d to ask for Money. Spare ’em that Pain, and they will love you. When you receive a Sum of Money, divide it among ’em in Proportion to your Debts. Don’t be asham’d of paying a small Sum because you owe a greater. Money, more or less, is always welcome; and your Creditor had rather be at the Trouble of receiving Ten Pounds voluntarily brought him, tho’ at ten different Times or Payments, than be oblig’d to go ten Times to demand it before he can receive it in a Lump. It shews, besides, that you are mindful of what you owe; it makes you appear a careful as well as an honest Man; and that still encreases your Credit.
Beware of thinking all your own that you possess, and of living accordingly. ’Tis a Mistake that many People who have Credit fall into. To prevent this, keep an exact Account for some Time of both your Expences and your Incomes. If you take the Pains at first to mention Particulars, it will have this good Effect; you will discover how wonderfully small trifling Expences mount up to large Sums, and will discern what might have been, and may for the future be saved, without occasioning any great Inconvenience.
In short, the Way to Wealth, if you desire it, is as plain as the Way to Market. It depends chiefly on two Words, INDUSTRY and FRUGALITY; i.e. Waste neither Time nor Money, but make the best Use of both.4 He that gets all he can honestly, and saves all he gets (necessary Expences excepted) will certainly become RICH; If that Being who governs the World, to whom all should look for a Blessing on their honest Endeavours, doth not in his wise Providence otherwise determine.

Richard Feynman and Charlie Munger: Expert Generalists


Richard Feynman was a scientist, professor, musician and raconteur. Bill Gates adds to that description Feynman:In 1965, Feynman shared a Nobel Prize for work on particle physics. Feynman wasn’t famous just for being a great teacher and a world-class scientist; he was also quite a character. He translated Mayan hieroglyphics. He loved to play the bongos. While helping develop the atomic bomb at Los Alamos, he entertained himself by figuring out how to break into the safes that contained top-secret research.” The Cambridge History of Science includes this text: “No doubt some of his peers dismissed Feynman’s interest in literature, art, and music as just as embarrassingly irrelevant to physics as his frequenting of strip clubs.” Rochus Vogt, a Caltech physics professor, former provost, and former division chair in Physics, Mathematics, and Astronomy adds: “He was not only a top-notch physicist, but he was an artist, a Renaissance type of person. He had certain insights and perceptions in physics that I have no word to describe other than ‘artistic.'”

Bill Gates and others have said similar things about Charlie Munger, who also has a very broad range of interests and activities. Gates on Munger: “He is truly the broadest thinker I have ever encountered. From business principles to economic principles to the design of student dormitories to the design of a catamaran he has no equal… Our longest correspondence was a detailed discussion on the mating habits of naked mole rats and what the human species might learn from them.”

Both Munger and Feynman are examples of what Bain Chairwoman Orit Gadiesh describes as an “expert-generalist.” Gadiesh has said the term describes: “Someone who has the ability and curiosity to master and collect expertise in many different disciplines, industries, skills, capabilities, countries, and topics., etc. He or she can then, without necessarily even realizing it, but often by design: Draw on that palette of diverse knowledge to recognize patterns and connect the dots across multiple areas. Drill deep to focus and perfect the thinking.” I would add that expert generalists have other qualities such as being intellectually humble and inquisitive, openness to experience and having a need fin. They also think probabilistically, accept that some areas are inherently uncertain and are open to new ideas. Expert generalists include people like Sir Alex Ferguson, Marie Curie, Pablo Picasso, Bill Gates, Elon Musk, Steve Jobs, Leonardo Da Vinci and Ben Franklin. A similar term for expert generalist is polymath, but they are not quit ethe same thing.

Here’s Munger describing himself, in effect advocating for an “expert generalist” approach:  “For some odd reason, I had an early and extreme multidisciplinary cast of mind. I couldn’t stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else’s discipline. So I just grabbed in all directions for the big ideas that would really work. Nobody taught me to do that; I was just born with that yen.” And: “the first rule is that you can’t really know anything if you just remember isolated facts and try and bangem back.”

Michael Mauboussin describes what you should be looking for as follows:

You want to determine who has a high rationality quotient, or the ability to make good decisions. A lot of that boils down to what’s called “epistemic rationality,” a fancy way of saying that your beliefs map accurately to the world. There are sets of characteristics of the kinds of people who are actively open minded. They incorporate lots of information and various points of view, and they update their view when new information comes in.

As is usual on this blog, the Feynman quotes are in bold text. Munger’s ideas are in the commentary in regular text.

  1. “Imagine how much harder physics would be if electrons had feelings!” Trying to use formulas from physics in investing and economics can lead to some conclusions that are problematic. Charlie Munger describes what the right balance is in this way: ‘Economics should emulate physics’ basic ethos, but its search for precision in physics-like formulas is almost always wrong in economics.” Munger has also said: “Max Planck the great Nobel laureate who found Planck’s Constant, tried once to do economics. He gave it up. Now why did Max Planck, one of the smartest people who ever lived, give up economics? The answer is, he said, “It’s too hard. The best solution you can get is messy and uncertain.” Investing and economics will never be as predictable as physics since the systems involved are complex adaptive systems. If you do not understand economics you do not understand the world. But if it is all that you know and use, you are a danger to yourself and others. Orson Scott Card said once in a slightly different domain: “You know the old saying: To a man with a hammer, everything looks like a nail. Well, that’s only sometimes true. In the case of the academic-literary establishment — the community I lovingly call “li-fi” — the better analogy is: To a man with only a hammer, a screw is a defective nail.”


  1. “I’m smart enough to know that I’m dumb.” Humility and the mental model of a “circle of competence” are critically important for successful investing since the best way to be smart is to not be dumb. The most effective way to be not dumb is to know what you are doing. Munger believes: “You are a disaster if you don’t know the edge of your competency. I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” Isaac Asimov once made the point humorously:  “Those people who think they know everything are a great annoyance to those of us who do.” The old joke “You can always tell a physicist, but you can’t tell him much” just does not apply to someone like Feynman. As an example of his intellectual humility Feynman once said: “I think I can safely say that nobody understands quantum mechanics. … I am going to tell you what nature behaves like. If you will simply admit that maybe she does behave like this, you will find her a delightful, entrancing thing. Do not keep saying to yourself, if you can possibly avoid it, ‘But how can it be like that?’, because you will get ‘down the drain’, into a blind alley from which nobody has escaped. Nobody knows how it can be like that.”


  1. “The first principle is that you must not fool yourself and you are the easiest person to fool.” “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong.” This is the Feynman quotation which Charlie Munger likes to cite when he is talking about the many dysfunctional biases that make up what he calls “the psychology of human misjudgment.” Understanding behavioral economics is helpful to making better decisions but it is not a panacea. As Daniel Kahneman says, you can study human psychological bias for decades and yet still fall for it. Not fooling yourself is a lifetime struggle – it never ends. Stephen Jay Gould put it this way once: “The most erroneous stories are those we think we know best–and therefore never scrutinize or question.”


  1. “I never pay attention to anything by ‘experts’. I calculate everything myself.” Working through an analysis from first principles generates big rewards and often an edge versus other investors who follow the crowd or an analyst with conflicted motives.  Munger likes to say: “Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life. But we’ve turned that quirk into a positive outcome for ourselves.” Marvin Minsky said about Feynman: “When he faces a problem, he’s unusually good at going back to being like a child, ignoring what everyone else thinks… He was so unstuck — if something didn’t work, he’d look at it another way.”


  1. “There are 10^11 stars in the galaxy. That used to be a huge number. But it’s only a hundred billion. It’s less than the national deficit! We used to call them astronomical numbers. Now we should call them economical numbers.” Big numbers are funny. I was once in a bank and because I was dealing with large numbers at work I wrote a check for 20 million dollars somewhat absent mindedly when the right amount was $20. No matter how many zeros are involved, the underlying investing principles remain the same. Janet Lowe writes in her book Damn Right: “Munger has said that accumulating the first $100,000 from a standing start, with no seed money, is the most difficult part of building wealth. Making the first million was the next big hurdle. To do that a person must consistently under spend his income. Getting wealthy, he explains, is like rolling a snowball. It helps to start on top of a long hill—start early and try to roll that snowball for a very long time. It helps to live a long life.”


  1. “For a successful technology, reality must take precedence over public relations, for Nature cannot be fooled.” Public relations is a funny thing. That means both funny in the sense of strange and funny in the sense of haha. One weird attribute of humans is how much people fall for news reports that are essentially press releases. Briefly stated, Gell-Mann Amnesia effect works as follows says Michael Crichton: “You open the newspaper to an article on some subject you know well. In Murray’s case, physics. In mine, show business. You read the article and see the journalist has absolutely no understanding of either the facts or the issues. Often, the article is so wrong it actually presents the story backward-reversing cause and effect. I call these the “wet streets cause rain” stories. Paper’s full of them.” A Feynman biographer named Lawrence Krauss has said on this point: “the greatest lesson I’d like to leave with – for Feynman, is that it’s nature that tells us how it behaves. And if we want to learn how the universe works, we have to get our answers from nature. And we have to be willing to go fearlessly in that direction and do whatever is possible to find out. And Feynman was nothing if not fearless.”


  1. “You can know the name of that bird in all the languages of the world, but when you’re finished, you’ll know absolutely nothing whatever about the bird. You’ll only know about humans in different places, and what they call the bird. … I learned very early the difference between knowing the name of something and knowing something.” Munger makes the same point: “You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life.” And “It’s not given to human beings to have such talent that they can just know everything all the time. The law student in the book The Paper Chase with a photographic memory failed. To be an investing success you must think and understand, not just recall.


  1. “Everything is interesting if you go into it deeply enough.” I have found that even people you may find boring have interesting things to say if you bore into a subject that they are passionate about. I once spent a few hours talking on an airplane to someone who knew just about everything about fishing in the Gulf of Alaska. Munger says: “The game is to keep learning, and I don’t think people are going to keep learning who don’t like the learning process.” If you do not have a broad education is is hard to understand anything really. Munger has developed himself into an expert generalist to complement areas where he has a circle of competence. “You have to realize the truth of biologist Julian Huxley’s idea that ‘Life is just one damn relatedness after another’ So you must have the models, and you must see the relatedness and the effects from the relatedness.”


  1. “Physics is like sex: sure, it may give some practical results, but that’s not why we do it.” Having passion for what you do is important. Passionate people are far more likely to do the required work since they enjoy it.  If you are not passionate about investing you should buy a diversified portfolio of low cost index funds. Munger believes: “You need to have a passionate interest in why things are happening. That cast of mind, kept over long periods, gradually improves your ability to focus on reality.” Also from Munger: “Like Warren, I had a considerable passion to get rich. “Not because I wanted Ferraris– I wanted the independence. I desperately wanted it. I thought it was undignified to have to send invoices to other people. I don’t know where I got that notion from, but I had it.”


  1. “I think it is much more interesting to live not knowing than to have answers that might be wrong… In order to make progress, one must leave the door to the unknown ajar.” Munger has said something that is quite similar to the sentiment expressed by Feynman: “When I run into a paradox I think either I’m a total horse’s ass to have gotten to this point, or I’m fruitfully near the edge of my discipline. It adds excitement to life to wonder which it is.” Munger likes to say that if he does not destroy one of his most cherished ideas every year, it is a wasted year. Munger again: “We all are learning, modifying, or destroying ideas all the time. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”


  1. “There’s all kinds of myths and pseudoscience all over the place. I may be quite wrong, maybe they do know all these things, but I don’t think I’m wrong. You see, I have the advantage of having found out how hard it is to get to really know something, how careful you have to be about checking the experiments, how easy it is to make mistakes and fool yourself. I know what it means to know something, and therefore I see how they get their information and I can’t believe that they know it. They haven’t done the work necessary, haven’t done the checks necessary, haven’t taken the care necessary. I have a great suspicion that they don’t know, that this stuff is
    and that they’re intimidating people.”
    Munger says: “Organized common (or uncommon) sense — very basic knowledge — is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little.” Investors and speculators will often encounter people, usually salespeople, but not always, who try to intimidate them. Just say no to intimidation. Think for yourself. I have a friend who likes to say: ‘If someone tries to hand you a turd, say ‘no thanks’ and walk away.” this apprpach applied to ideas as well as other forms of turds.


  1. “Scientific knowledge is a body of statements of varying degrees of certainty — some most unsure, some nearly sure, but none absolutely certain.” “We absolutely must leave room for doubt or there is no progress and no learning. People search for certainty. But there is no certainty.” “I have approximate answers and possible beliefs in different degrees of certainty about different things, but I’m not absolutely sure of anything.” Predictions are hard to make correctly, especially about the future is an old joke. Many people try to get away with predicting the present and calling themselves futurists. Munger points out: “We have the same problem as everyone else: It’s very hard to predict the future… If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one legged man in an ass kicking contest. You’re giving a huge advantage to everybody else.” In his book Margin of Safety Seth Klarman writes:

“Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.”

Stephen Hawking puts it this way: “The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.” Stay passionate, but stay humble too. Never stop learning. Be an expert generalist if you can.

The right decision making process has two steps:  Know your circle of competence. If the bet is not in your circle of competence don’t invest.If you decide that it is wise to make a bet based on your circle of competence then use your skill as a expert generalist to check your decision. Do everything make sense base don worldly wisdom too? Munger: “Common stock investors can make money by predicting the outcomes of practice evolution. You can’t derive this by fundamental analysis — you must think biologically” and “I find it quite useful to think of a free market economy—or partly free market economy—as sort of the equivalent of an ecosystem.” “Acquire worldly wisdom and adjust your behavior accordingly. If your new behavior gives you a little temporary unpopularity with your peer group … then to hell with them.”“If you skillfully follow the multidisciplinary path, you will never wish to come back. It would be like cutting off your hands.” “It’s kind of fun to sit there and out think people who are way smarter than you are because you’ve trained yourself to be more objective and more multidisciplinary. Furthermore, there is a lot of money in it, as I can testify from my own personal experience.”



 What was left on Feynman’s blackboard after he died.

The Feynman Lectures: http://www.feynmanlectures.caltech.edu/


Feynman Talk: Cargo Cult Science https://www.lhup.edu/~DSIMANEK/cargocul.htm


Feynman Talk: There’s Plenty of Room at the Bottom: http://www.zyvex.com/nanotech/feynman.html


Feynman Nobel Lecture: http://www.nobelprize.org/nobel_prizes/physics/laureates/1965/feynman-lecture.html


Michael Crichton on Gell-Mann Amnesia:  http://www.goodreads.com/quotes/65213-briefly-stated-the-gell-mann-amnesia-effect-is-as-follows-you


Damn Right:  http://www.amazon.com/gp/product/0471446912?ie=UTF8&tag=jpin


Feynman Videos:  http://www.richard-feynman.net/videos.htm


NPR on Feynman: http://www.npr.org/2011/03/25/134855903/Richard-Feynman-Is-The-Quantum-Man

CalTech:  http://m.caltech.edu/news/physics-world-poll-names-richard-feynman-one-10-greatest-physicists-all-time-368




A Dozen Things I’ve Learned from South Park About Investing

1. “Phase 1: Collect underpants.  Phase 2: ?  Phase 3: Profit.” Eric Cartman. Underpants Gnomes. http://southpark.wikia.com/wiki/Gnomes/Script

The business model problem flagged in the Underpants Gnomes episode of South Park is real since creating a significantly profitable business model is hard. Not only is it hard, it is rare. Many important companies have done it exactly once. And companies that have created a successful business model are often not able to hold on to that profit for very long. The competitive pressure that markets put on any source of profit are formidable. Significant amounts of failure are an inevitable part of capitalism. But so is some level of success.

An important part of human nature is a tendency to turn away from hard problems and focus instead on something easy. Charlie Munger once described psychological denial in this way:”If you turn on the television you find the mothers of the most obvious criminals that man could ever diagnose and they all think their sons are innocent. The reality is too painful to bear so you just distort it until it’s bearable. We all do it to some extent. It’s a common psychological misjudgment that causes terrible problems.” Unfortunately, humans will often falsely believe that they have solved “?” for their business model due to psychological denial. The best entrepreneurs don’t fall prey to this and instead are laser focused on finding real solutions.


2. “Start up. Cash in. Sell out. Bro down.” Eric Cartman. Go Fund Yourself. http://southpark.wikia.com/wiki/Go_Fund_Yourself/Script



Many people want to start a business for the wrong reasons. Venture capitalists who have been profiled in this series talk about wanting missionaries as company founders rather than mercenaries. They feel this way in no small part since a founder who is a missionary can be counted on to stay focused on the tasks that will drive the company forward. The mercenary will be less likely to persevere in the face of inevitable adversity. Mercenaries will sometimes find success, but not nearly as often.


3. Bank Clerk: How can I help you, young man?

Stan Marsh: I got a hundred-dollar check from my grandma and my dad said I need to put it in the bank so it can grow over the years.

Bank Clerk: Well that’s fantastic. A really smart decision, young man. We can put that check in a money market mutual fund, then we’ll re-invest the earnings into foreign currency accounts with compounding interest aaaand it’s gone.

[Blank stares and silence as it goes from the Bank Clerk, to Stan, to the Bank Clerk, to Stan]

Stan Marsh: Uh… what?

Bank Clerk: It’s gone, it’s all gone.

Stan Marsh: What’s all gone?

Bank Clerk: The money in your account. It didn’t do too well, it’s gone.

Stan Marsh: What do you mean? I-I have a hundred dollars!

Bank Clerk: Not any more, you don’t. [Gestures]Bank Clerk: Poof!


MargaritaVille. http://southpark.wikia.com/wiki/Margaritaville/Script

Bank Clerk

When my children were born they were given some money by their grandparents. Their grandparents are very conservative and wanted that money put into a special children’s savings account (Dinosaver!) which paid interest (a quaint concept these days). My kids did not add or withdraw funds from that account since they were infants. Eventually the bank, without warning, transferred everything in the account to the state assuming that the money had been abandoned since the account was legally deemed to be inactive. This process, which is the law in some states, is called escheat. The bank eventually got the money back. But that story reminds me of the South Park script. More commonly the bank or investment firm just gives the customer bad advice and charges big fees that deplete the account. A rule of thumb is that the bigger the sales commission you are paying the worse the deal is for you since it is hard to sell a bad investment so a big sales commission is needed. The best approach to avoid this “aaand its gone” situation is to think for yourself. And do a lot of work. And have the right temperament. If you don’t want to do that or can’t do that, then buy a low cost diverse portfolio of index funds. When “dumb money” adopts this approach it is transformed into “smart money.”


4. “We thought we could make money on the Internet.” Kyle Broflovskin. Canada On Strike http://southpark.wikia.com/wiki/Canada_on_Strike/Script

The Internet is a wonderful means of distribution and it enables new business models. But the fundamental elements of a business remain the same even when the business is on-line. You must acquire a customer cost effectively, you must service that customer at a reasonable cost, the customer must stay a customer long enough and there must be enough revenue to make the whole thing work . All of this must be done in a way that does not result in the business running out of cash at any given point in time. If you are successful, others will try to copy you. More people copying you will result in lower prices. None of this is supposed to be easy. That’s capitalism. Otherwise everyone would be rich.



5. “Make the game about waiting. But let the player pay not to wait. It’s a surefire way to make lots of money.” Minister of Mobile Gaming. Freemium Isn’t Free. http://southpark.wikia.com/wiki/Freemium_Isn’t_Free/Script

Freemium is a natural business model in many businesses when the offering is digital and has zero or low marginal cost. By spending a relatively limited amount of money on the free items, customer acquisition cost (CAC) can drop dramatically. Because software has a marginal cost of almost zero (it costs almost no additional money to create more copies), there is a natural tendency for the price of software to drop to zero if there aren’t any barriers to entry. Of course, some free services have real storage or egress costs but the point remains true. This South Park episode goes into many of the psychological manipulations that are used in freemium games in some detail. The author of the PsiFi blog writes about the techniques used in business models like freemium:

“Operant conditioning is one of the oldest areas of modern psychology and arose out of the observation that people and animals can be conditioned to respond to stimuli in different ways. So if every time your dog chases a cat you give it an electric shock it’ll pretty soon figure out that chasing cats is not the pleasurable activity that instinct suggests. Although it may develop some strange theories about the remote electrical properties of cats. Psychologists used to love this stuff. Behaviourism, championed by B.F. Skinner – simultaneously a great man and one of the twentieth century’s worst examples of man with a hammer syndrome, insisted that operant conditioning explained all behaviour and refused to accept the possibility of the existence of an inner mental life. If he couldn’t measure it, it didn’t exist. So much for those flashes of inspiration we dream we have from time to time.”

Freemium not really


6. “Big corporations are good…because without big corporations we wouldn’t have things like cars and computers and canned soup.” Kyle. Underpants Gnomes. http://southpark.wikia.com/wiki/Gnomes/Script

Scale economies are an important part of human progress. Jamie Dimon has pointed out that: “Economies of scale are a good thing. If we didn’t have them, we’d still be living in tents and eating buffalo.” Elon Musk has said: “There are really two things that have to occur in order for a new technology to be affordable to the mass market. One is you need economies of scale. The other is you need to iterate on the design. You need to go through a few versions.”



7. “It’s simple economics, son. I don’t understand it at all, but, God I love it.” Randy Marsh. Something Wall Mart This Way Comes. http://southpark.wikia.com/wiki/Something_Wall-Mart_This_Way_Comes/Script

The cacophony created by competing schools of economics is enough to confuse anyone. For example, heterodox, MMT, Keynesian, Post-Keynesian, Austrian, anarchist, freshwater, monetarist, saltwater, socialist, new classical, Marxist…



8. “Little boy, sometimes, what’s right isn’t as important as what’s profitable.” Agent. Prehistoric Ice Man. http://wiki.southpark.cc.com/wiki/Prehistoric_Ice_Man

There are certain profitable business that are odious from a moral standpoint. As an example, for Charlie Munger, operating a casino is one of these businesses. Or selling cigarettes. He is OK that Costco is a distributor of cigarettes. Everyone must draw the line somewhere. Munger points out: “You’ll make more money in the end with good ethics than bad. Even though there are some people who do very well, like Marc Rich–who plainly has never had any decent ethics, or seldom anyway. But in the end, Warren Buffett has done better than Marc Rich–in money–not just in reputation.”



9. “Well just like the rest of us, you have to make choices with your money. Do you want a bike, or do you not want to be depressed?” Randy. Trapped in the Closet. http://southpark.wikia.com/wiki/Trapped_in_the_Closet/Script

Deferred gratification is hard to accomplish, especially for some people. People use discount rates that vary and for some people any deferral of gratification is nearly impossible. Charlie Munger puts it this way: “It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.” In addition, people also do crazy things out of envy. As an example, for every $1,000 increase in a lottery prize, bankruptcy filings by the winner’s neighbors rise by 2.4%. If you can shut feelings of envy down, life inevitably gets better. Nothing good comes from envy. It is all downside. There are lot of ways to create motivation that do not involve envy.



10. “We got so caught up in the little things of Christmas, like love and family that we almost forgot it’s buying things that makes our economy thrive.” Ms. Choksondick. A Very Crappy Christmas http://southpark.wikia.com/wiki/A_Very_Crappy_Christmas/Script

Paul Krugman  has said on the Paradox of Thrift:

Suppose a large group of people decides to save more. You might think that this would necessarily mean a rise in national savings. But if falling consumption causes the economy to fall into a recession, incomes will fall, and so will savings, other things equal. This induced fall in savings can largely or completely offset the initial rise. Which way it goes depends on what happens to investment, since savings are always equal to investment. If the central bank can cut interest rates, investment and hence savings may rise. But if the central bank can’t cut rates — say, because they’re already zero — investment is likely to fall, not rise, because of lower capacity utilization. And this means that GDP and hence incomes have to fall so much that when people try to save more, the nation actually ends up saving less. http://krugman.blogs.nytimes.com/2009/07/07/the-paradox-of-thrift-for-real/?_r=0



11. “Excuse me son, I’m an investment broker; I can help you invest that money.” Broker “Nuh uh, I’m spendin’ it.” Cartman. Cartmanland. http://southpark.wikia.com/wiki/Cartmanland/Script

The principal problem in dealing with financial advisers is known as “incentive-caused” bias. Munger puts it this way: “Both in one’s own mind and that in one’s trusted adviser … [this bias] causes perfectly terrible behavior. Take sales presentations of brokers of commercial real estate businesses. I’m 70 years old and I’ve never seen one that I thought was even within hailing distance of objective truth.” In asking your barber whether you need a haircut, there is natural incentive-caused bias. Seeking independent financial advice in situations where where incentives may not be aligned is wise.

investment broker


12. “Man, I guess sometimes we let our technology and stuff grow too fast.” Kyle. Trapper Keeper http://southpark.wikia.com/wiki/Trapper_Keeper/Script

Technology and innovation help drive the progress in the world’s standard of living but that inevitably creates disruption. That disruption can be good or bad depending on who you are. Consumers always benefit. As for a given business, as Charlie Munger says:

“The great lesson in microeconomics is to discriminate between when technology is going to help you and when it’s going to kill you. And most people do not get this straight in their heads.

There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.”

What Munger talks about above confuses many people since they assume that technological progress always increases revenue and profit. Anyone involved in a real business knows that sometimes an innovative new technology results in less revenue and profit.

This is as it should be in a capitalist system, but nevertheless there are winners and losers as Nassim Taleb writes:

“Like Britain in the Industrial Revolution, America’s asset is, simply, risk taking and the use of optionality, this remarkable ability to engage in rational forms of trial and error, with no comparative shame in failing again, starting again, and repeating failure.” “Most of you will fail, disrespected, impoverished, but we are grateful for the risks you are taking and the sacrifices you are making for the sake of the economic growth of the planet and pulling others out of poverty. You are the source of our antifragility. Our nation thanks you.”

In his recent shareholder letter Warren Buffett writes about the need for a safety net:

“Nothing rivals the market system in producing what people want – nor, even more so, in delivering what people don’t yet know they want. … For 240 years it’s been a terrible mistake to bet against America, and now is no time to start. America’s golden goose of commerce and innovation will continue to lay more and larger eggs…. Though the pie to be shared by the next generation will be far larger than today’s, how it will be divided will remain fiercely contentious. Just as is now the case, there will be struggles for the increased output of goods and services between those people in their productive years and retirees, between the healthy and the infirm, between the inheritors and the Horatio Algers, between investors and workers and, in particular, between those with talents that are valued highly by the marketplace and the equally decent hard-working Americans who lack the skills the market prizes.”

tech pic.jpg


B.F. Skinner’s Stockmarket Slot MachinesWin Big, Win Rarely, Win Never http://www.psyfitec.com/2009/06/bf-skinners-stockmarket-slot-machines.html

A Dozen Things I’ve Learned from Richard Thaler about Investing

Richard Thaler is not only a famous economist and author, but is also part of a very successful fund said Bloomberg in an article published just today:

The 70-year-old University of Chicago professor, whose stock-picking theories drive the Undiscovered Managers Behavioral Value Fund, is getting discovered in more ways than one. The small-cap mutual fund, which beat 99 percent of its Bloomberg peers over the past three and five years, has almost doubled in size to $3.7 billion during the past 12 months as investor deposits surged. “What we try to do is put academic research to use,” Thaler said in an interview this month in Los Angeles. “We’re interested in the dogs that are going to look better….“We’re an active manager, so we think we can beat the market by a little most of the time,” he said. “Our methods are kind of a hybrid. We don’t fit neatly into a single quant versus judgmental box. We use judgment based on academic-style rigorous testing.”


1. “Behavioral economics [is] a field that only exists because regular economics is based on an idealized economic agent, sometimes called Homo Economicus. In the book we refer to such creatures as Econs. Econs are creatures that can calculate like a super computer, never get tempted by fatty or sweet foods, never get distracted, and probably aren’t a whole lot of fun to be around. In contrast, real people, who in the book we call humans, don’t make any appearance in standard economics. Behavioral economics is economics about humans. Humans are busy, can’t solve every problem instantaneously, and get tempted by luscious desserts. Sometimes they need some help.” Some economists believe that introducing ideas from psychology into economics is an admission that ideas from economics might be less valuable. In actual fact introducing a greater degree of realism into the profession causes the credibility of economics to rise rather than fall, especially among people who are not economists. In other words, people like Thaler who work to bring psychology into economics increase the credibility of the profession and as a side effect make jokes about economists “assuming a can opener” less funny. It would certainly make life easier if humans and an economy were as predictable as the systems in a physics experiment. But even a small child knows that assumptions such as one that assumes humans are perfectly informed rational agents do not tie in any reasonable way to reality.  The joke that economists have predicted nine of the past five recession is humorous for a reason since the core of humor is truth. The more the economics profession becomes reality-based by adopting the ideas of people like Thaler, the better it will be perceived.

2. “Models of Econs may provide a good approximations of what happens in the real world…. but those situations are the exception rather than the rule.” I like this phrasing in a recent blog post by Allison Schrager: “Economics offers a series of parables to help us understand how the economy works. The parables are abstractions that make many simplifying assumptions because the world is too complicated to capture in a simple model.” The value of economics that Schrager talks about is a very good thing for society. Charlie Munger has written an essay on the strengths and weakness of economics, that includes this text about strengths:

“Economics was always more multidisciplinary than the rest of soft science. It just reached out and grabbed things as it needed to. And that tendency to just grab whatever you need from the rest of knowledge if you’re an economist reached a fairly high point in Mankiw’s textbook (Principles of Economics). I checked out that textbook. I must have been one of the few businessmen in America that bought it immediately when it came out because it had gotten such a big advance. And there I found laid out as principles of economics: opportunity cost is a superpower, to be used by all people who have any hope of getting the right answer. Also, incentives are superpowers. And lastly, the tragedy of the commons model, popularized by UCSB’s Garrett Hardin.”

The ideas from economics like Munger mentions above are essential mental models that must be part of any investor’s worldly wisdom. Others include comparative advantage, competitive advantage and creating destruction just to mention three that starts with the letter “c”. That economics reaches out and grabs ideas from other disciplines is a good is a very good thing argues Munger, but assuming that an economy can be modeled using the same assumptions and formulas that would be applied to physical systems is, in Munger’s view, folly. What Thaler calls “a good approximation” should not only be the goal, but a critical idea to apply so as to avoid mistakes caused by hubris. It is far better to be approximately right than precisely wrong.

3. “The combination of free entry, unfettered competition, and free choice seems hard to quarrel with.… However, if participants are not well-informed or highly motivated, then maximizing choice may not lead to the best possible outcome.” “If people starting new businesses on average believe that their chance of succeeding is 75% then that should be a good estimate of the actual number that do succeed. Econs are not overconfident.” “Economists assume people are unboundedly unscrupulous—or I’ll say self-interested, a more polite term. But there have been lots of experiments where you leave a wallet out and depending on the place—I don’t remember the exact data—but a large percentage get returned.” “There’s no reason to think that markets always drive people to what’s good for them.” “Most economists recognize that some of the people are not fully rational some of the time, and some of the time that matters.” Charlie Munger again says it better than I can:

“How could economics not be behavioral? If it isn’t behavioral, what the hell is it? And I think it’s fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there’s anything valid in psychology, economics has to recognize it, and vice versa. So I think the people that are working on this fringe between economics and psychology are absolutely right to be there…”

4. “Most of economic theory is not derived from empirical observation. Instead it is deduced from axioms of rational choice, whether or not those axioms bear any relation to what we observe in our lives every day. A theory of the behavior of Econs cannot be empirically based, because Econs do not exist.” Empirical data can be based on the idea that humans are, well, human. The contributions of people like Kahneman and Thaler on this point are enormous. Economics becoming more empirical is only helpful if it is reality-based. I recommend Thaler’s books on this point and other sources which I link to in the notes.

5. “You can [beat the market] but it is difficult.” Warren Buffett once said: “I’d be a bum on the street with a tin cup if the markets were always efficient.” His partner Charlie Munger adds: “There’s no way to make investing easy. Anyone who finds it easy, you’re living in an illusion.” “I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.”

6. “In some ways the, the venerable Ben Graham has been given a Fama-French seal of approval, since they also endorse value and profitability.” Fama-French endorses value as a statistical factor which is sort of an endorsement of value as an analytical style (Ben Graham). But the two approaches are very different. A portfolio composed of hundreds of stocks in the form of an index is very different from a portfolio selected on a bottoms up fundamental basis that may only have 10 stocks in it. I have written about this point on my blog before and I link to it in the notes below. Thaler is correct in making the statement the quotation but one must be careful to not conflate value as a statistical factor and value as an analytical style.

7. “Rational models are one hundred percent flexible. If you allow time-varying discount rates, there is no discipline whatsoever. If you look at what happened to tech stocks and then to real estate, and you say maybe there wasn’t a bubble—where is the discipline in that?” Those of us who lived through the Internet crash in 2001 know that bubbles exist. One particular example of silliness is often cited, in this case by Burton Malkiel: “in one celebrated case during the Internet bubble, the market price of Palm Pilot stock (which was 95 percent owned by the company 3Com) implied a total capitalization considerably greater than that of its parent, suggesting that the rest of 3Com’s business had a negative value. But the arbitrage (sell Palm stock short and buy 3Com stock) could not be achieved because it was impossible to borrow Palm Pilot stock to accomplish the short sale.” The Internet bubble was a time when people went bonkers due to fear of missing out. People like Thaler who explain and remind us why people are often not rational are helpful to civilization.

8. Diversification Bias: “When an employee is offered n funds to choose from in her retirement plan, she divides the money evenly among the funds offered. Use of this heuristic, or others only slightly more sophisticated, implies that the asset allocation an investor chooses will depend strongly on the array of funds offered in the retirement plan. Thus, in a plan that offered one stock fund and one bond fund, the average allocation would be 50% stocks, but if another stock fund were added, the allocation to stocks would jump to two thirds.” This quotation and its implications raises the question of whether ordinary people should be making their own investment decisions. Can nudges be enough? I tend to think not. Soft paternalism isn’t enough in my view since the negative spillovers for society are simply too big to let people do so poorly investing their retirement money since they end up living in poverty as elderly adults. I understand that some people believe my view is too paternalistic. But a  year does not pass that I don’t get more convinced that most people are incapable of investing wisely when left to their own devices. I agree with Charlie Munger that efforts some time ago to privatize social security were a deeply flawed idea. I link below in the notes to a recent New York Times article entitled “Nudges Aren’t Enough for Problems like Retirement Savings.” The article notes: “Automatic enrollment in retirement accounts counts as the most successful nudge yet tested on a large scale [But] only 40 percent of American families in the bottom half of the income distribution have any form of retirement savings plan. And even among those who have one, their savings total, on average, is just $40,000.” Nudges are great but sometimes are not enough.

9. Loss Aversion: “When they have to give something up, they are hurt more than they are pleased if they acquire the very same thing.” You can see loss aversion in human behavior in many settings if you know where and how to look for it. It is almost always combined with other biases so loss aversion (also called Prospect theory) varies in the way it presents itself. New findings and support for the existence and impact of loss aversion bias are still appearing in the literature. For example,

“according to a new study, occur when people are so desperate to avoid them that they blunder into them. It’s like a child worried about missing a fly ball or dropping a pass, or a newlywed husband fearful he will drop his new bride as he carries her across the threshold; once it’s in the mind — and the person starts to adjust thinking drastically to avoid it — that’s when the trouble starts. The new research from Dr. Rui Yao, an associate professor of personal finance at the University of Missouri, identified risk factors for people who are “more likely to make investment mistakes during a down market,” and found that aversion to losses was the key character trait.”

10. The House Money Effect: “The money that has recently been won is called ‘house money’ because in gambling parlance the casino is referred to as the house. Betting some of the money that you have just won is referred to as ‘gambling with the house’s money,’ as if it were, somehow, different from some other kind of money. Experimental evidence reveals that people are more willing to gamble with money that they consider house money.” Prior gain can increase a person’s willingness to accept bets involving greater risk and uncertainty. In other words, the potential for gains or losses is considered by humans relative to a reference point, rather than calculated on the basis of the absolute level of wealth. Thaler and Johnson have called this phenomenon: “prospect theory, with memory.”

11. Status Quo Bias: “Hundreds of studies confirm that human forecasts are flawed and biased. Human decision making is not so great either. Again to take just one example, consider what is called the ‘status quo bias,’ a fancy name for inertia. For a host of reasons, which we shall explore, people have a strong tendency to go along with the status quo or default option.” Sales and marketing departments love status quo bias. For example, magazines often offer free trials or issues at a reduced price if the customer agrees that the business can continue to send them issues until they actively end the subscription. When making decisions people tend to follow the adage: “when in doubt, do nothing.” For this reason, getting a customer’s credit card information is a holy grail for marketers, who hate it when credit cards expire. Customers know this to some degree, which means they are reticent to hand out their credit card data even for a free trial. The incentives must be significant to obtain customer credit card data as a result.

12. Optimism Bias: “The ‘above average’ effect is pervasive. Ninety percent of all drivers think they are above average behind the wheel.” “People are unrealistically optimistic even when the stakes are high.” “I think the people who’ve been the most overconfident in our business in the last decade have been the people that called themselves risk managers. And the reason is they failed to learned the primary lesson we should have learned from when Long Term Capital Management went belly up ten years ago. That is, investments that seem uncorrelated can be correlated simply because we’re interested in it. …the world is much more correlated than we give credit to. And so we see more of what Nassim Taleb calls ‘black swan events’– rare events happen more often than they should because the world is more correlated. I think one lesson we have to learn is that there’s a lot more risk than we’re giving credit to, a lot more what economist calls systematic risk. I think we also have learned the lesson that we have to have better incentive structures.” I have met Thaler and find him not only to be a delightful and insightful, person but also an to be an optimist. Optimism is good quality to have as long as it does not become a dysfunctional bias. When people talk about optimism bias it always reminds me of a story:

A family had twin boys, whose only resemblance to each other was their looks. If one felt the temperature was too hot, the other thought it was too cold. If one said the television was too loud, the other claimed the volume needed to be turned up. Opposite in every way, one boy was an eternal optimist, the other boy a total pessimist. On the twins’ birthday their psychologist father loaded the pessimist’s room with every imaginable toy and game. The optimist’s room was loaded with a huge pile of horse manure. That night the father passed by the pessimist’s room and found him sitting next to his many gifts crying bitterly.

“Why are you crying?” the father asked.

“Because my friends will be envious, I’ll have to read all these instructions before I can do anything with these toys and games, I will constantly need new batteries, and they will eventually get broken.” answered the pessimist twin.

Passing the optimist twin’s room, the father found him dancing for joy in the middle of the pile of manure. “What are you so happy about?” he asked.

The optimist twin boy replied, “There just must be a pony in here somewhere!”



My post on Fama-French: https://25iq.com/2014/03/16/ben-grahams-value-investing-%e2%89%a0-famafrenchs-factor-investing/

My post on Kahneman https://25iq.com/2013/07/18/a-dozen-things-ive-learned-about-investing-from-daniel-kahneman/

Nudges Aren’t Enough for Problems like Retirement Savings.  http://www.nytimes.com/2016/02/24/business/economy/nudges-arent-enough-to-solve-societys-problems.html?_r=0

Thaler article in Bloomberg:  http://www.bloomberg.com/news/articles/2016-02-26/-big-short-professor-s-fund-swells-as-theory-works-in-reality

Charlie Munger on economics: https://www.farnamstreetblog.com/2015/03/charlie-munger-academic-economics/

Allison Schrager: http://qz.com/611394/economics-education-is-awesome/

Burton Malkiel https://www.princeton.edu/ceps/workingpapers/200malkiel.pdf

Dr. Rui Yao research: http://www.seattletimes.com/business/for-investors-fear-of-loss-can-be-costly/

Interview with John Cassidy http://www.newyorker.com/news/john-cassidy/interview-with-richard-thaler

Interview https://www.minneapolisfed.org/publications/the-region/interview-with-richard-thale r

Misbehaving: The Making of Behavioral Economics (2015) http://www.amazon.com/Misbehaving-Behavioral-Economics-Richard-Thaler-ebook/dp/B00NUB4GFQ/ref=sr_1_4?s=books&ie=UTF8&qid=1425185963&sr=1-4&keywords=thaler

Nudge: Improving Decisions About Health, Wealth, and Happiness http://www.amazon.com/Nudge-Improving-Decisions-Health-Happiness/dp/014311526X/ref=sr_1_1?s=books&ie=UTF8&qid=1425185963&sr=1-1&keywords=thaler

The Winner’s Curse http://www.amazon.com/Winners-Curse-Paradoxes-Anomalies-Economic/dp/0691019347/ref=sr_1_2?s=books&ie=UTF8&qid=1425185963&sr=1-2&keywords=Thaler